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EX-32.2 - EXHIBIT 32.2 - PACIFIC MERCANTILE BANCORPex-3222017q3.htm
EX-32.1 - EXHIBIT 32.1 - PACIFIC MERCANTILE BANCORPex-3212017q3.htm
EX-31.2 - EXHIBIT 31.2 - PACIFIC MERCANTILE BANCORPex-3122017q3.htm
EX-31.1 - EXHIBIT 31.1 - PACIFIC MERCANTILE BANCORPex-3112017q3.htm

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
 
 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2017
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                     to                    
Commission file number 0-30777
 
PACIFIC MERCANTILE BANCORP
(Exact name of Registrant as specified in its charter)
 
California
 
33-0898238
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
949 South Coast Drive, Suite 300, Costa Mesa, California
 
92626
(Address of principal executive offices)
 
(Zip Code)
(714) 438-2500
(Registrant’s telephone number, including area code)
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “non-accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
 
o
  
Accelerated filer
 
x
Non-accelerated filer
 
o
  
Smaller reporting company
 
o
 
 
 
 
Emerging growth company
 
o

1


If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Securities Exchange Act Rule 12b-2). Yes  ¨    No  x
As of November 1, 2017, there were 23,189,550 shares of Common Stock outstanding.
 

2


PACIFIC MERCANTILE BANCORP
QUARTERLY REPORT ON FORM 10Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2017
TABLE OF CONTENTS
 
 
Page No.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


3




PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Dollars in thousands, except for per share data)
(Unaudited)
 
September 30, 2017
 
December 31, 2016
ASSETS
 
 
 
Cash and due from banks
$
15,186

 
$
16,789

Interest bearing deposits with financial institutions
92,687

 
122,056

Cash and cash equivalents
107,873

 
138,845

Interest-bearing time deposits with financial institutions
3,419

 
3,669

Federal Reserve Bank of San Francisco and Federal Home Loan Bank Stock, at cost
7,790

 
8,170

Securities available for sale, at fair value
41,935

 
43,480

Loans (net of allowances of $15,048 and $16,801, respectively)
1,027,896

 
931,525

Accrued interest receivable
3,565

 
2,702

Premises and equipment, net
1,150

 
1,257

Other assets
11,333

 
11,041

Total assets
$
1,204,961

 
$
1,140,689

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Deposits:
 
 
 
Noninterest-bearing
$
320,248

 
$
332,573

Interest-bearing
734,272

 
668,727

Total deposits
1,054,520

 
1,001,300

Borrowings
15,000

 
15,000

Accrued interest payable
272

 
201

Other liabilities
7,383

 
6,942

Junior subordinated debentures
17,527

 
17,527

Total liabilities
1,094,702

 
1,040,970

Commitments and contingencies (Note 10)

 

Shareholders’ equity:
 
 
 
Common stock, no par value, 85,000,000 shares authorized; 23,188,650 and 23,004,668 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively
150,269

 
148,680

Accumulated deficit
(39,082
)
 
(47,119
)
Accumulated other comprehensive loss
(928
)
 
(1,842
)
Total shareholders’ equity
110,259

 
99,719

Total liabilities and shareholders’ equity
$
1,204,961

 
$
1,140,689

The accompanying notes are an integral part of these consolidated financial statements.

4


PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except for per share data)
(Unaudited)
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
Interest income:
 
 
 
 
 
 
 
Loans, including fees
$
13,386

 
$
9,998

 
$
35,927

 
$
28,700

Securities available for sale and stock
304

 
356

 
930

 
1,075

Interest-bearing deposits with financial institutions
335

 
244

 
904

 
613

Total interest income
14,025

 
10,598

 
37,761

 
30,388

Interest expense:
 
 
 
 
 
 
 
Deposits
1,845

 
1,240

 
4,792

 
3,513

Borrowings
175

 
169

 
497

 
502

Total interest expense
2,020

 
1,409

 
5,289

 
4,015

Net interest income
12,005

 
9,189

 
32,472

 
26,373

Provision for loan and lease losses

 
10,730

 

 
19,870

Net interest income (loss) after provision for loan and lease losses
12,005

 
(1,541
)
 
32,472

 
6,503

Noninterest income
 
 
 
 
 
 
 
Service fees on deposits and other banking services
346

 
279

 
985

 
801

Net gain on sale of small business administration loans

 

 

 
40

Net loss on sale of other assets
(16
)
 

 
(14
)
 

Other noninterest income
634

 
775

 
2,393

 
1,830

Total noninterest income
964

 
1,054

 
3,364

 
2,671

Noninterest expense
 
 
 
 
 
 
 
Salaries and employee benefits
5,796

 
5,727

 
17,171

 
16,920

Occupancy
659

 
794

 
1,958

 
2,332

Equipment and depreciation
430

 
502

 
1,248

 
1,374

Data processing
377

 
340

 
1,063

 
942

FDIC expense
294

 
229

 
859

 
675

Other real estate owned expense, net

 

 

 
(70
)
Professional fees
958

 
1,110

 
3,100

 
2,435

Business development
139

 
199

 
496

 
543

Loan related expense
(5
)
 
152

 
194

 
264

Insurance
62

 
69

 
186

 
221

Other operating expense
466

 
565

 
1,374

 
1,499

Total noninterest expense
9,176

 
9,687

 
27,649

 
27,135

Income (loss) before income taxes
3,793

 
(10,174
)
 
8,187

 
(17,961
)
Income tax provision
37

 
20,352

 
150

 
16,991

Net income (loss) allocable to common shareholders
$
3,756

 
$
(30,526
)
 
$
8,037

 
$
(34,952
)
Basic income (loss) per common share:
 
 
 
 
 
 
 
Net income (loss) available to common shareholders
$
0.16

 
$
(1.33
)
 
$
0.35

 
$
(1.52
)
Diluted income (loss) per common share:
 
 
 
 
 
 
 
Net income (loss) available to common shareholders
$
0.16

 
$
(1.33
)
 
$
0.35

 
$
(1.52
)
Weighted average number of common shares outstanding:
 
 
 
 
 
 
 
Basic
23,192,994

 
22,996,426

 
23,172,810

 
22,944,120

Diluted
23,331,413

 
22,996,426

 
23,290,068

 
22,944,120

The accompanying notes are an integral part of these consolidated financial statements.

5


PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands)
(Unaudited)
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
Net income (loss)
$
3,756

 
$
(30,526
)
 
$
8,037

 
$
(34,952
)
Other comprehensive income, net of tax:
 
 
 
 
 
 
 
Change in unrealized gain on securities available for sale
262

 
(264
)
 
914

 
366

Total comprehensive income (loss)
$
4,018

 
$
(30,790
)
 
$
8,951

 
$
(34,586
)
The accompanying notes are an integral part of these consolidated financial statements.


6


PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Shares and dollars in thousands)
(Unaudited)
For the Nine Months Ended September 30, 2017
  
Common stock
 
Retained
earnings
(accumulated
deficit)
 
Accumulated
other
comprehensive
income (loss)
 
Total
Number
of shares
 
Amount
 
Balance at December 31, 2016
23,005

 
$
148,680

 
$
(47,119
)
 
$
(1,842
)
 
$
99,719

Issuance of restricted stock, net
11

 

 

 

 

Common stock based compensation expense

 
593

 

 

 
593

Common stock options exercised
173

 
996

 

 

 
996

Net income

 

 
8,037

 

 
8,037

Other comprehensive income

 

 

 
914

 
914

Balance at September 30, 2017
23,189

 
$
150,269

 
$
(39,082
)
 
$
(928
)
 
$
110,259

The accompanying notes are an integral part of these consolidated financial statements.


7


PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)
 
Nine Months Ended September 30,
 
2017
 
2016
Cash Flows From Operating Activities:
 
 
 
Net income (loss)
$
8,037

 
$
(34,952
)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
Depreciation and amortization
318

 
368

Provision for loan and lease losses

 
19,870

Amortization of premium on securities
172

 
213

Net amortization of deferred fees and unearned income on loans
(435
)
 
(186
)
Net gain on sales of other real estate owned

 
(107
)
Net gain on sale of premises and equipment
(2
)
 

Net loss on sale of other assets
16

 

Net gain on sale of small business administration loans

 
(40
)
Small business administration loan originations

 
(806
)
Proceeds from sale of small business administration loans

 
840

Stock-based compensation expense
593

 
807

Tax effect of restricted stock vesting

 
(16
)
Changes in operating assets and liabilities:
 
 
 
Net increase in accrued interest receivable
(863
)
 
(257
)
Net increase in other assets
(526
)
 
(912
)
Net decrease in deferred taxes

 
16,939

Net decrease in income taxes receivable
27

 
738

Net increase (decrease) in accrued interest payable
71

 
(4
)
Net increase (decrease) in other liabilities
441

 
(223
)
Net cash provided by operating activities
7,849

 
2,272

Cash Flows From Investing Activities:
 
 
 
Net decrease in interest-bearing time deposits with financial institutions
250

 
996

Maturities of and principal payments received on securities available for sale and other stock
5,700

 
6,041

Purchase of securities available for sale and other stock
(3,033
)
 

Purchase of other investments
(133
)
 
(87
)
Proceeds from sale of other real estate owned

 
757

Net increase in loans
(95,719
)
 
(25,715
)
Purchases of premises and equipment
(211
)
 
(524
)
Proceeds from sale of other assets
107

 

Proceeds from sale of premises and equipment
2

 

Net cash used in investing activities
(93,037
)
 
(18,532
)
Cash Flows From Financing Activities:
 
 
 
Net increase in deposits
53,220

 
56,326

Proceeds from borrowings
30,000

 

Payments of borrowings
(30,000
)
 
(10,000
)
Proceeds from exercise of common stock options
996

 
455

Net cash provided by financing activities
54,216

 
46,781

Net (decrease) increase in cash and cash equivalents
(30,972
)
 
30,521

Cash and Cash Equivalents, beginning of period
138,845

 
113,921

Cash and Cash Equivalents, end of period
$
107,873

 
$
144,442

Supplementary Cash Flow Information:
 
 
 
Cash paid for interest on deposits and other borrowings
$
5,218

 
$
4,019

Cash paid for income taxes
$
123

 
$
12

Non-Cash Investing Activities:
 
 
 
Transfer of loans into other assets
$
217

 
$

 The accompanying notes are an integral part of these consolidated financial statements.

8



1. Nature of Business
Organization
Pacific Mercantile Bancorp (“PMBC”) is a bank holding company which, through its wholly owned subsidiary, Pacific Mercantile Bank (the “Bank”), is engaged in the commercial banking business in Southern California. PMBC is registered as a one bank holding company under the United States Bank Holding Company Act of 1956, as amended, and, as such, is regulated by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) and the Federal Reserve Bank of San Francisco (“FRBSF”) under delegated authority from the Federal Reserve Board. Substantially all of our operations are conducted and substantially all of our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues, expenses, and income. The Bank provides a full range of banking services to small and medium-size businesses and professionals primarily in Orange, Los Angeles, San Bernardino and San Diego counties in Southern California and is subject to competition from, among other things, other banks and financial institutions and from financial services organizations conducting operations in those same markets. The Bank is chartered by the California Department of Business Oversight under the Division of Financial Institutions and is a member of the FRBSF. In addition, the deposit accounts of the Bank’s customers are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to the maximum amount allowed by law. PM Asset Resolution, Inc. (“PMAR”) is a wholly owned subsidiary of PMBC which exists for the purpose of purchasing certain non-performing loans and other real estate from the Bank and thereafter collecting on or disposing of those assets.
PMBC, the Bank and PMAR are sometimes referred to, together, on a consolidated basis, in this report as the “Company” or as “we”, “us” or “our”.

2. Significant Accounting Policies
Except as discussed below, our accounting policies are described in Note 2, Significant Accounting Policies of our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2016 (“Form 10-K”).
Interim Consolidated Financial Statements Basis of Presentation
Our interim consolidated financial statements are prepared in accordance with generally accepted accounting principles in effect in the United States (“GAAP”) for interim financial information pursuant to rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”), including instructions to Form 10-Q and Article 10 of Regulation S-X, on a basis consistent with prior periods. Our financial statements reflect all adjustments that are, in the opinion of management, necessary to present a fair statement of the results for the interim periods presented. The interim results are not necessarily indicative of operating results for the full year. The interim information should be read in conjunction with our audited consolidated financial statements in our Form 10-K.
Use of Estimates
The preparation of the financial statements in conformity with GAAP requires us to make certain estimates and assumptions that could affect the reported amounts of certain of our assets, liabilities, and contingencies at the date of the financial statements and the reported amounts of our revenues and expenses during the reporting periods. For the fiscal periods covered by this report, those estimates related primarily to our determinations of the allowance for loan and lease losses (“ALLL”), the fair values of securities available for sale, and the determination of the valuation allowance pertaining to deferred tax assets. If circumstances or financial trends on which those estimates were based were to change in the future or there were to occur any currently unanticipated events affecting the amounts of those estimates, our future financial position or results of operations could differ, possibly materially, from those expected at the current time.
Principles of Consolidation
Our consolidated financial statements for the three and nine months ended September 30, 2017 and 2016 include the accounts of PMBC, the Bank and PMAR. All significant intercompany balances and transactions were eliminated in consolidation. 
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers (Topic 606),” which amended its guidance on revenue recognition to conform with international accounting guidance under the International Accounting Standards Board. The ASU provides a framework for addressing revenue recognition and replaces most existing revenue recognition guidance, as well as requires increased disclosure requirements. In August 2015, the FASB issued ASU 2015-14 to defer the effective date of ASU 2014-09 by one year. Accordingly,

9


this guidance is effective for interim and annual periods beginning after December 15, 2017 with early adoption permitted for interim and annual periods beginning after December 15, 2016. We will adopt this guidance on January 1, 2018 using the modified retrospective approach. We do not expect any significant impact as the accounting for interest income on loans and investments, loan service fee income, prepayment fees, and loan origination fees are excluded from the scope of this standard.
In August 2014, the FASB issued ASU 2014-15, “Presentation of Financial Statements — Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern,” which defines management's responsibility to evaluate whether there is substantial doubt about an organization's ability to continue as a going concern and clarifies when to provide related footnote disclosure. This guidance is effective for interim and annual periods beginning after December 15, 2016. Early adoption was permitted. We adopted this guidance on January 1, 2017 and it had no effect on our consolidated financial statements.
In January 2016, the FASB issued ASU 2016-01, “Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities,” which enhances the reporting model for financial instruments to provide users of financial statements with more useful information. Some of the provisions include: requiring equity investments to be measured at fair value with changes in fair value recognized in net income, simplifying the impairment assessment of equity investments without readily determinable fair values, eliminating the requirement to disclose the method and significant assumptions used to estimate fair value on financial instruments measured at amortized cost on the balance sheet, requiring public business entities to use the exit price notion when measuring the fair value of financial instruments, requiring the reporting organization to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the organization has elected to measure the liability at fair value in accordance with the fair value option, requiring separate presentation of financial assets and liabilities by measurement category and form of financial asset on the balance sheet or notes to the financial statements, and clarifying that the reporting organization should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the organization's other deferred tax assets. This guidance is effective for interim and annual periods beginning after December 15, 2017. Early adoption is not permitted for public companies. We will adopt this guidance on January 1, 2018. We do not expect adoption of this guidance to have a material impact on our consolidated financial statements as we only have one available-for-sale equity investment where the change in fair value will be recognized in net income, as compared to the current practice of flowing through other comprehensive income.
In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842),” which requires lessees to recognize the following for all leases (with the exception of short-term leases) at the commencement date: a lease liability measured on a discounted basis and a right-of-use asset a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged and the accounting for sale and leaseback transactions were simplified. This guidance is effective for interim and annual periods beginning after December 15, 2018. Early adoption is permitted. We will adopt this guidance on January 1, 2019. We expect our statement of financial condition to be grossed up on both the asset and liability side to reflect our lease obligations, and we do not expect adoption of this guidance to have a material impact on our other consolidated financial statements or on our disclosures related to leases.
In March 2016, the FASB issued ASU 2016-09, “Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting,” which simplifies how several aspects of share-based payments are accounted for and presented in the financial statements. Under the new guidance, some of the aspects that are simplified include: income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. This guidance is effective for interim and annual periods beginning after December 15, 2016. Early adoption was permitted. We adopted this guidance on January 1, 2017. As of December 31, 2016, we had excess tax benefits of approximately $211 thousand for which a benefit could not be previously recognized. Upon adoption, the balance of the unrecognized excess tax benefits was reversed with the impact recorded to retained earnings including any change to the valuation allowance as a result of the adoption.  Due to the full valuation allowance on the deferred tax assets, there was no impact to our consolidated financial statements as a result of this adoption. Upon adoption of this guidance, we elected to recognize forfeitures as they occur instead of applying an estimated forfeiture rate to each grant, which was the previous practice. The recorded impact to our beginning retained earnings was less than $10 thousand and not considered material. On a prospective basis, we expect the new guidance could create quarterly volatility in our noninterest expense as forfeitures occur.
In June 2016, the FASB issued ASU 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments,” which requires the measurement of all expected credit losses for financial assets held at the reporting date, based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions will now use forward-looking information to better inform their credit loss estimates. Additionally, the ASU amends the accounting guidance for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. This guidance is effective for interim and annual periods beginning after December 15, 2019. Early adoption is permitted for interim and annual periods beginning after December 15, 2018. We will adopt this guidance on January 1, 2020 and expect that it will

10


have a material impact on the determination of our ALLL and an increased ALLL. We are unable to estimate the expected impact to the ALLL upon adoption due to various factors, primarily the uncertainty regarding economic conditions and the size and mix of our loan portfolio at the time of adoption, which could impact our historical loss factors. We are currently working with our existing ALLL software provider on gathering the supplemental data needed to perform the ALLL calculations upon adoption and we believe that we currently have in place the internal team capable of handling this implementation.
In August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments,” which provides guidance for classification of specific items on the statement of cash flows. This guidance is effective for interim and annual periods beginning after December 15, 2017. Early adoption is permitted. We will adopt this guidance on January 1, 2018 and do not expect it to have a material impact on our statement of cash flows.
In January 2017, the FASB issued ASU 2017-03, “Accounting Changes and Error Corrections (Topic 250) and Investments - Equity Method and Joint Ventures (Topic 323): Amendments to SEC Paragraphs Pursuant to Staff Announcements at the September 22, 2016 and November 16, 2016 EITF Meetings,” which incorporates into FASB accounting standards recent SEC guidance requiring expanded disclosure on the effect of implementation in advance of a company's adoption of a new accounting standard, specifically those related to revenue recognition, leases, financial instruments and credit losses. This guidance was effective immediately. We adopted this guidance upon the date of issuance and have increased the disclosure of the effect of recently issued accounting standards on future periods in this Form 10-Q. We will continue to provide expanded disclosure and updates on the estimated effect of recently issued accounting guidance through the period of adoption. This guidance only affected the financial statement footnote disclosures and had no impact on the financial statements.
In May 2017, the FASB issued ASU 2017-09, “Compensation — Stock Compensation (Topic 718): Scope of Modification Accounting,” which provides guidance on determining which changes to the terms and conditions of share-based payment awards require an entity to apply modification accounting. This guidance is effective for interim and annual periods beginning after December 15, 2017. Early adoption is permitted. We will adopt this guidance on January 1, 2018 and do not expect it to have a material impact on our financial statements and disclosures.

3. Fair Value Measurements
Under FASB Accounting Standards Codification (“ASC”) 820-10, we group assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
Level 1
Valuation is based upon quoted prices for identical instruments traded in active markets.
 
 
Level 2
Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
 
 
Level 3
Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
Risks with Fair Value Measurements
Fair value estimates are made at a discrete point in time based on relevant market information and other information about the financial instruments. Because no active market exists for a significant portion of our financial instruments, fair value estimates are based in large part on judgments we make primarily regarding current economic conditions, risk characteristics of various financial instruments, prepayment rates, and future expected loss experience. These estimates are subjective in nature and invariably involve some inherent uncertainties. Additionally, the occurrence of unexpected events or changes in circumstances can occur that could require us to make changes to our assumptions and which, in turn, could significantly affect and require us to make changes to our previous estimates of fair value.
In addition, the fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of existing and anticipated future customer relationships and the value of assets and liabilities that are not considered financial instruments, such as premises and equipment and other real estate owned (“OREO”).
Measurement Methodology
Cash and Cash Equivalents. The fair value of cash and cash equivalents approximates its carrying value.

11


Interest-Bearing Deposits with Financial Institutions. The fair values of interest-bearing deposits maturing within one year approximate their carrying values.
FHLB and FRBSF Stock. The Bank is a member of the Federal Home Loan Bank of San Francisco (“FHLB”) and the FRBSF. As members, we are required to own stock of the FHLB and the FRBSF, the amount of which is based primarily on the level of our borrowings from those institutions. We also have the right to acquire additional shares of stock in either or both of the FHLB and the FRBSF. During the nine months ended September 30, 2017, we purchased $38 thousand of FHLB stock and no shares of FRBSF stock. During the nine months ended September 30, 2017, 8,354 shares, or $418 thousand, of FRBSF stock was called by FRBSF. No shares of FHLB stock or FRBSF stock were purchased or called during the three months ended September 30, 2017. The fair values of the FHLB and FRBSF stock are equal to their respective carrying amounts, are classified as restricted securities and are periodically evaluated for impairment based on our assessment of the ultimate recoverability of our investments in that stock. Any cash or stock dividends paid to us on such stock are reported as income.
Investment Securities Available for Sale. Fair value measurement for our investment securities available for sale is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 investment securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the- counter markets and money market funds. Level 2 investment securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.
Other Investments. Other investments accounted for under the cost method of accounting are carried at their respective carrying amounts and are periodically evaluated for impairment based on our assessment of the ultimate recoverability of our investment. In the event that there are no identified events or changes in circumstances that may have a significant adverse effect on the fair value of the investment and it is not practicable to estimate the fair value of the investment, then the fair value of such investment is not estimated. Any cash or stock dividends paid to us on such investments are reported as noninterest income.
Impaired Loans. Loans measured for impairment are measured at an observable market price (if available), or the fair value of the loan’s collateral (if the loan is collateral dependent). The fair value of an impaired loan may be estimated using one of several methods, including collateral value, market value of similar debt, liquidation value and discounted cash flows. Those impaired loans not requiring a specific loan loss reserve represent loans for which the fair value of the expected repayments or collateral exceeds the recorded investments in such loans. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan at Level 2. When an appraised value is not available or we determine that the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the impaired loan at Level 3.
Loans. The fair value for loans with variable interest rates less a credit discount is the carrying amount. The fair value of fixed rate loans is derived by calculating the present value of expected future cash flows discounted at the loan’s original interest rate by the various homogeneous categories of loans. All loans have been adjusted to reflect changes in credit risk. Changes are not recorded directly as an adjustment to current earnings or comprehensive income, but rather as an adjustment component in determining the overall adequacy of the loan loss reserve.
Other Foreclosed Assets. Other foreclosed assets is reported at its net realizable value (fair value less estimated costs to sell), at the time any collateral other than real estate is acquired by the Bank in satisfaction of a loan. Subsequently, other foreclosed assets are carried at the lower of carrying value or fair value less estimated costs to sell. Fair value is determined based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the foreclosed asset at Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the foreclosed asset at Level 3.

Deposits. Deposits are carried at historical cost. The carrying amounts of deposits from savings and money market accounts are deemed to approximate fair value as they either have no stated maturities or short-term maturities. Certificates of deposit are estimated utilizing discounted cash flow techniques. The interest rates applied are rates currently being offered for similar certificates of deposit.
Borrowings. The fair value of borrowings is the carrying amount for those borrowings that mature on a daily basis. The fair value of term borrowings is derived by calculating the discounted value of future cash flows expected to be paid out by the Company. We classify our borrowings in Level 2 of the fair value hierarchy.

12


Junior Subordinated Debentures. The fair value of the junior subordinated debentures is based on quoted market prices of the underlying securities. These securities are variable rate in nature and repriced quarterly. We classify our junior subordinated debentures in Level 2 of the fair value hierarchy.
Commitments to Extend Credit and Standby Letters of Credit. The fair value of commitments to extend credit and standby letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.
Interest Receivable and Interest Payable. The carrying amounts of our accrued interest receivable and accrued interest payable are deemed to approximate fair value.
Assets Recorded at Fair Value on a Recurring Basis
The following tables show the recorded amounts of assets and liabilities measured at fair value on a recurring basis at September 30, 2017 and December 31, 2016:
 
At September 30, 2017
(Dollars in thousands)
Total
 
Level 1
 
Level 2
 
Level 3
Assets at Fair Value:
 
 
 
 
 
 
 
Investment securities available for sale
 
 
 
 
 
 
 
U.S. Treasury securities
$
2,987

 
$
2,987

 
$

 
$

Residential mortgage backed securities issued by U.S. agencies
31,918

 

 
31,918

 

Residential collateralized mortgage obligations issued by non-agency
404

 

 
404

 

Asset-backed security
1,690

 

 

 
1,690

Mutual funds
4,936

 
4,936

 

 

Total securities available for sale at fair value
$
41,935

 
$
7,923

 
$
32,322

 
$
1,690

 
 
At December 31, 2016
(Dollars in thousands)
Total
 
Level 1
 
Level 2
 
Level 3
Assets at Fair Value:
 
 
 
 
 
 
 
Investment securities available for sale
 
 
 
 
 
 
 
Residential mortgage backed securities issued by U.S. agencies
$
36,675

 
$

 
$
36,675

 
$

Residential collateralized mortgage obligations issued by non-agency
468

 

 
468

 

Asset-backed security
1,433

 

 

 
1,433

Mutual funds
4,904

 
4,904

 

 

Total securities available for sale at fair value
$
43,480

 
$
4,904

 
$
37,143

 
$
1,433


The changes in Level 3 assets measured at fair value on a recurring basis are summarized as follows for the nine months ended September 30, 2017:
 
Asset Backed Securities
 
(Dollars in thousands)
Balance of recurring Level 3 instruments at December 31, 2016
$
1,433

Total gains or losses (realized/unrealized):
 
Included in other comprehensive income
257

Balance of recurring Level 3 instruments at September 30, 2017
$
1,690

Assets Recorded at Fair Value on a Nonrecurring Basis
We may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets. Information regarding assets measured at fair value on a nonrecurring basis is set forth in the table below.

13


 
At September 30, 2017
 
At December 31, 2016
(Dollars in thousands)
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
Assets at Fair Value:
 
 
 
Impaired loans
$
10,768

 
$

 
$

 
$
10,768

 
$
24,897

 
$

 
$

 
$
24,897

Other foreclosed assets
95

 

 
95

 

 

 

 

 

Total
$
10,863

 
$

 
$
95

 
$
10,768

 
$
24,897

 
$

 
$

 
$
24,897

 
Significant Unobservable Inputs and Valuation Techniques of Level 3 Fair Value Measurements
For our fair value measurements classified in Level 3 of the fair value hierarchy as of September 30, 2017, a summary of the significant unobservable inputs and valuation techniques is as follows:
 
Fair Value Measurement as of September 30, 2017
 
Valuation Techniques(3)
 
Unobservable Inputs(3)
 
Range
 
Weighted Average
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
 
 
Asset-backed security
$
1,690

 
Third-Party Pricing
 
Marketability discount
 
N/A (1)
 
N/A (1)
 
 
 
 
 
Illiquidity discount
 
N/A (1)
 
N/A (1)
Impaired loans
10,768

 
Third-Party Pricing
 
Discounted cash flow
 
N/A (2)
 
N/A (2)
 
$
12,458

 
 
 
 
 
 
 
 
 
(1)
Information is unavailable as valuation was obtained from third-party pricing services.
(2)
As part of our process, we obtain appraisals for our various properties included within impaired loans which primarily rely upon market comparisons. These market comparisons support our assumption that the carrying value of the respective loans either requires or does not require additional impairment.
(3)
As of September 30, 2017, there has been no change to our valuation techniques or the types of unobservable inputs used in the calculation of fair value from December 31, 2016.
Fair Value Measurements for Other Financial Instruments
The table below provides estimated fair values and related carrying amounts of our financial instruments as of September 30, 2017 and December 31, 2016, excluding financial assets and liabilities which are recorded at fair value on a recurring basis.
 
Estimated Fair Value
At September 30, 2017
 
At December 31, 2016
Carrying Value
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Carrying Value
 
Total
 
Level 1
 
Level 2
 
Level 3
 
(Dollars in thousands)
Financial assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
107,873

 
$
107,873

 
$
107,873

 
$

 
$

 
$
138,845

 
$
138,845

 
138,845

 

 

Interest-bearing deposits with financial institutions
3,419

 
3,419

 
3,419

 

 

 
3,669

 
3,669

 
3,669

 

 

Federal Reserve Bank of San Francisco and Federal Home Loan Bank stock
7,790

 
7,790

 
7,790

 

 

 
8,170

 
8,170

 
8,170

 

 

Loans, net
1,027,896

 
1,020,111

 

 

 
1,020,111

 
931,525

 
928,885

 

 

 
928,885

Accrued interest receivable
3,565

 
3,565

 
3,565

 

 

 
2,702

 
2,702

 
2,702

 

 

Financial liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Noninterest bearing deposits
320,248

 
320,248

 
320,248

 

 

 
332,573

 
332,573

 
332,573

 

 

Interest-bearing deposits
734,272

 
734,006

 

 
734,006

 

 
668,727

 
668,089

 

 
668,089

 

Borrowings
15,000

 
15,000

 

 
15,000

 

 
15,000

 
15,000

 

 
15,000

 

Junior subordinated debentures
17,527

 
17,527

 

 
17,527

 

 
17,527

 
17,527

 

 
17,527

 

Accrued interest payable
272

 
272

 
272

 

 

 
201

 
201

 
201

 

 



14


4. Investments
Securities Available For Sale, at Fair Value
The following table sets forth the major components of securities available for sale and compares the amortized costs and estimated fair market values of, and the gross unrealized gains and losses on, these securities at September 30, 2017 and December 31, 2016:
(Dollars in thousands)
September 30, 2017
 
December 31, 2016
Amortized
Cost
 
Gross Unrealized
 
Estimated
Fair Value
 
Amortized
Cost
 
Gross Unrealized
 
Estimated
Fair Value
Gain
 
Loss
 
Gain
 
Loss
 
Securities Available for Sale
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$
2,995

 
$

 
$
(8
)
 
$
2,987

 
$

 
$

 
$

 
$

Residential mortgage backed securities issued by U.S. Agencies(1)
32,469

 
7

 
(558
)
 
31,918

 
37,813

 
6

 
(1,144
)
 
36,675

Residential collateralized mortgage obligations issued by non-agencies(1)
399

 
5

 

 
404

 
484

 

 
(16
)
 
468

Asset backed security(2)
2,000

 

 
(310
)
 
1,690

 
2,025

 

 
(592
)
 
1,433

Mutual funds(3)
5,000

 
16

 
(80
)
 
4,936

 
5,000

 
11

 
(107
)
 
4,904

Total
$
42,863

 
$
28

 
$
(956
)
 
$
41,935

 
$
45,322

 
$
17

 
$
(1,859
)
 
$
43,480

 
 
(1)
Secured by closed-end first liens on 1-4 family residential mortgages.
(2)
Comprised of a security that represents an interest in a pool of trust preferred securities issued by U.S.-based banks and insurance companies.
(3)
Consists primarily of mutual fund investments in closed-end first liens on 1-4 family residential mortgages.
At September 30, 2017 and December 31, 2016, U.S. agency residential mortgage backed securities with an aggregate fair market value of $22.8 million and $21.1 million, respectively, were pledged to secure repurchase agreements, local agency deposits and treasury, tax and loan accounts.
The amortized cost and estimated fair values of securities available for sale at September 30, 2017 and December 31, 2016 are shown in the tables below by contractual maturities taking into consideration historical prepayments based on the prior twelve months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, primarily because prepayment rates are affected by changes in conditions in the interest rate market and, therefore, future prepayment rates may differ from historical prepayment rates.
 
At September 30, 2017 Maturing in
(Dollars in thousands)
One year
or less
 
Over one
year through
five years
 
Over five
years through
ten years
 
Over ten
Years
 
Total
Securities available for sale, amortized cost
$
6,779

 
$
24,808

 
$
8,759

 
$
2,517

 
$
42,863

Securities available for sale, estimated fair value
6,680

 
24,545

 
8,612

 
2,098

 
41,935

Weighted average yield
1.60
%
 
1.57
%
 
1.59
%
 
3.52
%
 
1.70
%
 
At December 31, 2016 Maturing in
(Dollars in thousands)
One year
or less
 
Over one
year through
five years
 
Over five
years through
ten years
 
Over ten
Years
 
Total
Securities available for sale, amortized cost
$
8,068

 
$
24,014

 
$
9,933

 
$
3,307

 
$
45,322

Securities available for sale, estimated fair value
7,831

 
23,344

 
9,619

 
2,686

 
43,480

Weighted average yield
1.48
%
 
1.52
%
 
1.58
%
 
2.76
%
 
1.62
%
During the three and nine months ended September 30, 2017, we purchased $2.0 million and $3.0 million, respectively, of securities available for sale. No securities available for sale were purchased during the three and nine months ended September 30, 2016. We had no sales of securities available for sale during the three and nine months ended September 30, 2017 and 2016.
The tables below indicate, as of September 30, 2017 and December 31, 2016, the gross unrealized losses and fair values of our investments, aggregated by investment category, and length of time that the individual securities have been in a continuous unrealized loss position.

15


 
Securities with Unrealized Loss at September 30, 2017
 
Less than 12 months
 
12 months or more
 
Total
(Dollars in thousands)
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
U.S. Treasury securities
$
2,987

 
$
(8
)
 
$

 
$

 
$
2,987

 
$
(8
)
Residential mortgage backed securities issued by U.S. Agencies
13,765

 
(123
)
 
17,657

 
(435
)
 
31,422

 
(558
)
Residential collateralized mortgage obligations issued by non-agencies

 

 

 

 

 

Asset backed security

 

 
1,690

 
(310
)
 
1,690

 
(310
)
Mutual funds
3,206

 
(44
)
 
964

 
(36
)
 
4,170

 
(80
)
Total
$
19,958

 
$
(175
)
 
$
20,311

 
$
(781
)
 
$
40,269

 
$
(956
)
  
Securities With Unrealized Loss as of December 31, 2016
 
Less than 12 months
 
12 months or more
 
Total
(Dollars in thousands)
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
Residential mortgage backed securities issued by U.S. Agencies
$
16,110

 
$
(267
)
 
$
19,975

 
$
(877
)
 
$
36,085

 
$
(1,144
)
Residential collateralized mortgage obligations issued by non-agencies

 

 
468

 
(16
)
 
468

 
(16
)
Asset-backed security

 

 
1,433

 
(592
)
 
1,433

 
(592
)
Mutual funds
3,185

 
(65
)
 
957

 
(42
)
 
4,142

 
(107
)
Total
$
19,295

 
$
(332
)
 
$
22,833

 
$
(1,527
)
 
$
42,128

 
$
(1,859
)
We regularly monitor investments for significant declines in fair value. We have determined that declines in the fair values of these investments below their respective amortized costs, as set forth in the tables above, are temporary because (i) those declines were due to interest rate changes and not to a deterioration in the creditworthiness of the issuers of those investment securities, and (ii) we have the ability to hold those securities until there is a recovery in their values or until their maturity.
We recognize other-than-temporary impairments (“OTTI”) to our available-for-sale debt securities in accordance with FASB ASC 320-10. When there are credit losses associated with, but we have no intention to sell, an impaired debt security, and it is more likely than not that we will not have to sell the security before recovery of its cost basis, we will separate the amount of impairment, or OTTI, between the amount that is credit related and the amount that is related to non-credit factors. Credit-related impairments are recognized in our consolidated statements of operations. Any non-credit-related impairments are recognized and reflected in other comprehensive income in our consolidated statements of financial condition.
Through the impairment assessment process, we determined that the available-for-sale securities discussed below were other-than-temporarily impaired at September 30, 2017. We recorded no impairment credit losses on available-for-sale securities in our consolidated statements of operations for the three and nine months ended September 30, 2017 and 2016. The OTTI related to factors other than credit losses, in the aggregate amount of $310 thousand, and was recognized as other comprehensive loss in our accompanying consolidated statement of financial condition as of September 30, 2017.

The table below presents, for the nine months ended September 30, 2017, a roll-forward of OTTI in those instances when a portion of the OTTI was attributable to non-credit related factors and, therefore, was recognized in other comprehensive loss:
(Dollars in thousands)
Gross Other-
Than-
Temporary
Impairments
 
Other-Than-
Temporary
Impairments
Included in Other
Comprehensive
Loss
 
Net Other-Than-
Temporary
Impairments
Included in
Retained  Earnings
(Deficit)
Balance – December 31, 2016
$
(1,145
)
 
$
(592
)
 
$
(553
)
Change in market value on a security for which an OTTI was previously recognized
257

 
257

 

Principal received on OTTI security
25

 
25

 

Balance – September 30, 2017
$
(863
)
 
$
(310
)
 
$
(553
)

16


In determining the component of OTTI related to credit losses, we compare the amortized cost basis of each OTTI security to the present value of its expected cash flows, discounted using the effective interest rate implicit in the security at the date of acquisition.
As a part of our OTTI assessment process with respect to securities available for sale with unrealized losses, we consider available information about (i) the performance of the collateral underlying each such security, including any credit enhancements, (ii) historical prepayment speeds, (iii) delinquency and default rates, (iv) loss severities, (v) the age or “vintage” of the security, and (vi) any rating agency reports on the security. Significant judgments are required with respect to these and other factors in order to make a determination of the future cash flows that can be expected to be generated by the security.
Based on our OTTI assessment process, we determined that there is one asset-backed security in our portfolio of securities available for sale that was impaired as of September 30, 2017. This security is a multi-class, cash flow collateralized bond obligation backed by a pool of trust preferred securities issued by a diversified pool of 56 issuers that consisted of 45 U.S. depository institutions and 11 insurance companies at the time of the security’s issuance in November 2007. We purchased $3.0 million face amount of this security in November 2007 at a price of 95.21% for a total purchase price of $2.9 million, out of a total of $363 million of this security sold at the time of issuance. The security that we own (CUSIP 74042CAE8) is the mezzanine class B piece security with a variable interest rate of 3 month LIBOR plus 60 basis points, which had a rating of Aa2 and AA by Moody’s and Fitch, respectively, at the time of issuance in 2007.
As of September 30, 2017, the amortized cost of this security was $2.0 million with a fair value of $1.7 million, for an unrealized loss of approximately $310 thousand. As of September 30, 2017, the security had a Baa3 rating from Moody’s and a B rating from Fitch and had experienced $42.5 million in defaults (12.7% of total current collateral) and $7.0 million in deferring securities (2.1% of total current collateral) from issuance to September 30, 2017. As of September 30, 2017, the mezzanine class B tranche had $63.1 million in excess subordination.
We have made a determination that the remainder of our securities with respect to which there were unrealized losses as of September 30, 2017 are not other-than-temporarily impaired, because we have concluded that we have the ability to continue to hold those securities until their respective fair market values increase above their respective amortized costs or, if necessary, until their respective maturities. In reaching that conclusion we considered a number of factors and other information, which included: (i) the significance of each such security, (ii) the amount of the unrealized losses attributable to each such security, (iii) our liquidity position, (iv) the impact that retention of those securities could have on our capital position and (v) our evaluation of the expected future performance of these securities (based on the criteria discussed above).
Other Investments
As of September 30, 2017 and December 31, 2016, we had one investment in a limited partnership which was accounted for under the cost method of accounting and included within other assets on the consolidated statements of financial condition. During the nine months ended September 30, 2017, we had $133 thousand of contributions to the investment. We had no contributions to the investment during either the three months ended September 30, 2017 or September 30, 2016. We had $87 thousand in contributions to this investment during the nine months ended September 30, 2016. As of September 30, 2017 and December 31, 2016, our other investment was as follows:
 
September 30, 2017
 
December 31, 2016
 
(Dollars in thousands)
Investments accounted for under the cost method (1)
$
799

 
$
666

 
 
(1)
Represents the aggregate carrying amount of our investments that were not evaluated for impairment.

5. Loans and Allowance for Loan and Lease Losses
The loan portfolio consisted of the following at:

17


 
September 30, 2017
 
December 31, 2016
(Dollars in thousands)
Amount
 
Percent
 
Amount
 
Percent
Commercial loans
$
364,242

 
35.0
%
 
$
333,376

 
35.2
%
Commercial real estate loans – owner occupied
211,514

 
20.3
%
 
214,420

 
22.7
%
Commercial real estate loans – all other
235,319

 
22.6
%
 
173,223

 
18.3
%
Residential mortgage loans – multi-family
123,698

 
11.9
%
 
130,930

 
13.8
%
Residential mortgage loans – single family
27,983

 
2.7
%
 
34,527

 
3.6
%
Construction and land development loans
28,461

 
2.7
%
 
18,485

 
2.0
%
Consumer loans
48,801

 
4.7
%
 
41,563

 
4.4
%
Total loans
1,040,018

 
100.0
%
 
946,524

 
100.0
%
Deferred loan origination costs, net
2,926

 
 
 
1,802

 
 
Allowance for loan and lease losses
(15,048
)
 
 
 
(16,801
)
 
 
Loans, net
$
1,027,896

 
 
 
$
931,525

 
 
At September 30, 2017 and December 31, 2016, loans of approximately $642 million and $527 million, respectively, were pledged to secure borrowings obtained from the FHLB and to support our unfunded borrowing capacity. During the nine months ended September 30, 2017, we purchased $30.1 million of performing commercial real estate - owner occupied and commercial real estate - all other loans. No loans were purchased during the three months ended September 30, 2017. During the three and nine months ended September 30, 2016, we purchased $22.9 million and $52.8 million of performing residential multi-family loans.
Allowance for Loan and Lease Losses
The ALLL represents our estimate of credit losses in our loan and lease portfolio that are probable and estimable at the balance sheet date. We employ economic models that are based on bank regulatory guidelines, industry standards and our own historical loan loss experience, as well as a number of more subjective qualitative factors, to determine both the sufficiency of the ALLL and the amount of the provisions that are required to increase or replenish the ALLL.
 
The ALLL is first determined by (i) analyzing all classified loans (graded as “Substandard” or “Doubtful” under our internal asset quality grading parameters) on nonaccrual status for loss exposure and (ii) establishing specific reserves as needed. ASC 310-10 defines loan impairment as the existence of uncertainty concerning collection of all principal and interest in accordance with the contractual terms of a loan. For collateral dependent loans, impairment is typically measured by comparing the loan amount to the fair value of collateral, less estimated costs to sell, with any “shortfall” amount charged off. Other methods can be used in estimating impairment, including market price and the present value of expected future cash flows discounted at the loan’s original interest rate. We are an active lender with the U.S. Small Business Administration and collection of a percentage of the loan balance of many of the loans originated is guaranteed.  The ALLL reserves are calculated against the non-guaranteed loan balances. 
On a quarterly basis, we utilize a classification based loan loss migration model as well as review individual loans in determining the adequacy of the ALLL for homogenous pools of loans that are not subject to specific reserve allocations. Our loss migration analysis tracks 16 quarters of loan loss history and industry loss factors to determine historical losses by classification category for each loan type, except certain consumer loans (automobile, mortgage and credit cards). We then apply these calculated loss factors, together with qualitative factors based on external economic conditions and trends and internal assessments, to the outstanding loan balances in each homogenous group of loans, and then, using our internal asset quality grading parameters, we grade the loans as “Pass,” “Special Mention,” “Substandard” or “Doubtful”. We analyze impaired loans individually. This grading is based on the credit classifications of assets as prescribed by government regulations and industry standards and is separated into the following groups:
Pass: Loans classified as pass include current loans performing in accordance with contractual terms, installment/consumer loans that are not individually risk rated, and loans which exhibit certain risk factors that require greater than usual monitoring by management.
Special Mention: Loans classified as special mention, while generally not delinquent, have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in the Bank’s credit position at some future date.
Substandard: Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. There is a distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

18


Doubtful: Loans classified as doubtful have all the weaknesses inherent in a substandard loan, and may also be at delinquency status and have defined weaknesses based on currently existing facts, conditions and values making collection or liquidation in full highly questionable and improbable.
Set forth below is a summary of the activity in the ALLL during the three and nine months ended September 30, 2017 and 2016:
(Dollars in thousands)
Commercial
 
Real  Estate
 
Construction and Land
Development
 
Consumer 
and Single
Family
Mortgages
 
Unallocated
 
Total
ALLL in the three months ended September 30, 2017:
 
 
 
 
 
 
 
 
 
 
 
Balance at beginning of period
$
10,113

 
$
4,657

 
$
157

 
$
1,123

 
$
1,128

 
$
17,178

Charge offs
(2,228
)
 

 

 
(47
)
 

 
(2,275
)
Recoveries
140

 

 

 
5

 

 
145

Provision
1,140

 
(615
)
 
189

 
(89
)
 
(625
)
 

Balance at end of period
$
9,165

 
$
4,042

 
$
346

 
$
992

 
$
503

 
$
15,048

ALLL in the nine months ended September 30, 2017:
 
 
 
 
 
 
 
 
 
 
 
Balance at beginning of period
$
11,276

 
$
4,226

 
$
343

 
$
642

 
$
314

 
$
16,801

Charge offs
(2,694
)
 
(432
)
 

 
(161
)
 

 
(3,287
)
Recoveries
1,334

 

 
27

 
173

 

 
1,534

Provision
(751
)
 
248

 
(24
)
 
338

 
189

 

Balance at end of period
$
9,165

 
$
4,042

 
$
346

 
$
992

 
$
503

 
$
15,048

ALLL in the three months ended September 30, 2016:
 
 
 
 
 
 
 
 
 
 
 
Balance at beginning of period
$
8,703

 
$
3,828

 
$
226

 
$
672

 
$

 
$
13,429

Charge offs
(6,605
)
 
(1,118
)
 

 

 

 
(7,723
)
Recoveries
202

 

 

 
4

 

 
206

Provision
9,981

 
707

 
82

 
(40
)
 

 
10,730

Balance at end of period
$
12,281

 
$
3,417

 
$
308

 
$
636

 
$

 
$
16,642

ALLL in the nine months ended September 30, 2016:
 
 
 
 
 
 
 
 
 
 
 
Balance at beginning of period
$
6,639

 
$
5,109

 
$
282

 
$
686

 
$

 
$
12,716

Charge offs
$
(16,356
)
 
$
(1,119
)
 
$

 
$
540

 
$

 
$
(16,935
)
Recoveries
979

 
1

 

 
11

 

 
991

Provision
21,019

 
(574
)
 
26

 
(601
)
 

 
19,870

Balance at end of period
$
12,281

 
$
3,417

 
$
308

 
$
636

 
$

 
$
16,642


19


Set forth below is information regarding loan balances and the related ALLL, by portfolio type, as of September 30, 2017 and December 31, 2016.
(Dollars in thousands)
Commercial
 
Real  Estate
 
Construction and Land
Development
 
Consumer 
and Single
Family
Mortgages
 
Unallocated
 
Total
ALLL balance at September 30, 2017 related to:
 
 
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
$
451

 
$

 
$

 
$

 
$

 
$
451

Loans collectively evaluated for impairment
8,714

 
4,042

 
346

 
992

 
503

 
14,597

Total
$
9,165

 
$
4,042

 
$
346

 
$
992

 
$
503

 
$
15,048

Loans balance at September 30, 2017 related to:
 
 
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
$
7,846

 
$
2,748

 
$

 
$
174

 
$

 
$
10,768

Loans collectively evaluated for impairment
356,396

 
567,783

 
28,461

 
76,610

 

 
1,029,250

Total
$
364,242

 
$
570,531

 
$
28,461

 
$
76,784

 
$

 
$
1,040,018

ALLL balance at December 31, 2016 related to:
 
 
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
$
2,042

 
$

 
$

 
$

 
$

 
$
2,042

Loans collectively evaluated for impairment
9,234

 
4,226

 
343

 
642

 
314

 
14,759

Total
$
11,276

 
$
4,226

 
$
343

 
$
642

 
$
314

 
$
16,801

Loans balance at December 31, 2016 related to:
 
 
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
$
20,330

 
$
4,346

 
$

 
$
221

 
$

 
$
24,897

Loans collectively evaluated for impairment
313,046

 
514,227

 
18,485

 
75,869

 

 
921,627

Total
$
333,376

 
$
518,573

 
$
18,485

 
$
76,090

 
$

 
$
946,524


Credit Quality
The amounts of nonperforming assets and delinquencies that occur within our loan portfolio factor into our evaluation of the adequacy of the ALLL.
The following table provides a summary of the delinquency status of loans by portfolio type at September 30, 2017 and December 31, 2016:

20


(Dollars in thousands)
30-59 Days Past Due
 
60-89 Days Past Due
 
90 Days and Greater
 
Total Past Due
 
Current
 
Total Loans Outstanding
 
Loans >90 Days and Accruing
At September 30, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
245

 
$
1,316

 
$
2,212

 
$
3,773

 
$
360,469

 
$
364,242

 
$

Commercial real estate loans – owner-occupied

 

 

 

 
211,514

 
211,514

 

Commercial real estate loans – all other

 
955

 

 
955

 
234,364

 
235,319

 

Residential mortgage loans – multi-family

 

 

 

 
123,698

 
123,698

 

Residential mortgage loans – single family

 

 

 

 
27,983

 
27,983

 

Construction and land development loans

 

 

 

 
28,461

 
28,461

 

Consumer loans

 

 

 

 
48,801

 
48,801

 

Total
$
245

 
$
2,271

 
$
2,212

 
$
4,728

 
$
1,035,290

 
$
1,040,018

 
$

At December 31, 2016
 
Commercial loans
$
7,055

 
$

 
$
13,946

 
$
21,001

 
$
312,375

 
$
333,376

 
$

Commercial real estate loans – owner-occupied
275

 
2,341

 
1,003

 
3,619

 
210,801

 
214,420

 

Commercial real estate loans – all other
512

 
1,014

 

 
1,526

 
171,697

 
173,223

 

Residential mortgage loans – multi-family

 

 

 

 
130,930

 
130,930

 

Residential mortgage loans – single family

 

 

 

 
34,527

 
34,527

 

Construction and land development loans

 

 

 

 
18,485

 
18,485

 

Consumer loans
38

 

 

 
38

 
41,525

 
41,563

 

Total
$
7,880

 
$
3,355

 
$
14,949

 
$
26,184

 
$
920,340

 
$
946,524

 
$

Generally, the accrual of interest on a loan is discontinued when principal or interest payments become more than 90 days past due, unless we believe that the loan is adequately collateralized and it is in the process of collection. There were no loans 90 days or more past due and still accruing interest at September 30, 2017 or December 31, 2016. In certain instances, when a loan is placed on nonaccrual status, previously accrued but unpaid interest is reversed against current income. Subsequent collections of cash are applied as principal reductions when received (referred to as full nonaccrual basis of accounting), except when the ultimate collectability of principal is probable, in which case such payments are applied to accrued and unpaid interest, which is credited to income (referred to as nonaccrual cash basis of accounting). Non-accrual loans may be restored to accrual status when principal and interest become current and full repayment becomes expected.
The following table provides information with respect to loans on nonaccrual status, by portfolio type, as of September 30, 2017 and December 31, 2016:
 
September 30, 2017
 
December 31, 2016
 
(Dollars in thousands)
Nonaccrual loans:
 
 
 
Commercial loans
$
7,356

 
$
20,330

Commercial real estate loans – owner occupied
1,147

 
2,643

Commercial real estate loans – all other
1,602

 
1,703

Residential mortgage loans – single family
174

 
221

Total(1)
$
10,279

 
$
24,897

 
(1)    Nonaccrual loans may include loans that are currently considered performing loans.

21


 We classify our loan portfolio using internal asset quality ratings. The following table provides a summary of loans by portfolio type and our internal asset quality ratings as of September 30, 2017 and December 31, 2016:
 
September 30, 2017
 
December 31, 2016
 
(Dollars in thousands)
Pass:
 
 
 
Commercial loans
$
346,815

 
$
287,717

Commercial real estate loans – owner occupied
196,609

 
197,497

Commercial real estate loans – all other
233,717

 
169,292

Residential mortgage loans – multi family
123,698

 
130,930

Residential mortgage loans – single family
27,809

 
34,306

Construction and land development loans
28,461

 
18,485

Consumer loans
48,801

 
41,563

Total pass loans
$
1,005,910

 
$
879,790

Special Mention:
 
 
 
Commercial loans
$
7,020

 
$
4,672

Commercial real estate loans – owner occupied
10,161

 
7,834

Commercial real estate loans – all other

 
2,228

Total special mention loans
$
17,181

 
$
14,734

Substandard:
 
 
 
Commercial loans
$
10,407

 
$
37,668

Commercial real estate loans – owner occupied
4,744

 
9,089

Commercial real estate loans – all other
1,602

 
1,703

Residential mortgage loans – single family
174

 
221

Total substandard loans
$
16,927

 
$
48,681

Doubtful:
 
 
 
Commercial loans
$

 
$
3,319

Total doubtful loans
$

 
$
3,319

Total Loans:
$
1,040,018

 
$
946,524

Impaired Loans
A loan generally is classified as impaired when, in our opinion, principal or interest is not likely to be collected in accordance with the contractual terms of the loan agreement. We measure for impairments on a loan-by-loan basis, using either the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the loan is collateral dependent.
The following table sets forth information regarding impaired loans, at September 30, 2017 and December 31, 2016:
 
September 30, 2017
 
December 31, 2016
 
(Dollars in thousands)
Impaired loans:
 
Nonaccruing loans
$
9,178

 
$
15,966

Nonaccruing restructured loans
1,101

 
8,931

Accruing restructured loans (1)
489

 

Total impaired loans
$
10,768

 
$
24,897

Impaired loans less than 90 days delinquent and included in total impaired loans
$
8,557

 
$
9,948


22


The table below contains additional information with respect to impaired loans, by portfolio type, as of September 30, 2017 and December 31, 2016:
 
September 30, 2017
 
December 31, 2016
 
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance (1)
 
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance (1)
 
(Dollars in thousands)
No allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
2,866

 
$
5,522

 
$

 
$
17,021

 
$
19,048

 
$

Commercial real estate loans – owner occupied
1,146

 
1,392

 

 
2,643

 
4,335

 

Commercial real estate loans – all other
1,602

 
1,965

 

 
1,703

 
1,965

 

Residential mortgage loans – single family
174

 
185

 

 
221

 
225

 

Consumer loans

 

 

 

 

 

Total
5,788

 
9,064

 

 
21,588

 
25,573

 

With allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
4,980

 
$
5,191

 
$
451

 
$
3,309

 
$
4,764

 
$
2,042

Total
4,980

 
5,191

 
451

 
3,309

 
4,764

 
2,042

Total
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
7,846

 
$
10,713

 
$
451

 
$
20,330

 
$
23,812

 
$
2,042

Commercial real estate loans – owner occupied
1,146

 
1,392

 

 
2,643

 
4,335

 

Commercial real estate loans – all other
1,602

 
1,965

 

 
1,703

 
1,965

 

Residential mortgage loans – single family
174

 
185

 

 
221

 
225

 

Consumer loans

 

 

 

 

 

Total
10,768

 
14,255

 
451

 
24,897

 
30,337

 
2,042

 
(1)
When the discounted cash flows, collateral value or market price equals or exceeds the recorded investment in the loan, then specific reserves are not required to be set aside for the loan within the ALLL. This typically occurs when the impaired loans have been partially charged-off and/or there have been interest payments received and applied to the balance of the principal outstanding.
 
At September 30, 2017 and December 31, 2016, there were $5.8 million and $21.6 million, respectively, of impaired loans for which no specific reserves had been allocated because these loans, in our judgment, were sufficiently collateralized. Of the impaired loans at September 30, 2017 for which no specific reserves were allocated, $5.4 million had been deemed impaired in the prior year.

23


Average balances and interest income recognized on impaired loans, by portfolio type, for the three and nine months ended September 30, 2017 and 2016 were as follows:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
 
Average Balance
 
Interest Income Recognized
 
Average Balance
 
Interest Income Recognized
 
Average Balance
 
Interest Income Recognized
 
Average Balance
 
Interest Income Recognized
 
(Dollars in thousands)
No allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
8,547

 
$
19

 
$
14,556

 
$
1

 
$
13,628

 
$
89

 
$
12,852

 
$
279

Commercial real estate loans – owner occupied
1,164

 

 
2,557

 

 
1,653

 

 
2,408

 
3

Commercial real estate loans – all other
1,613

 

 
3,757

 

 
1,650

 

 
5,090

 

Residential mortgage loans – multi-family

 

 
430

 

 

 

 
437

 

Residential mortgage loans – single family
180

 

 
119

 

 
196

 

 
369

 
9

Construction and land development loans

 

 
570

 

 

 

 
1,088

 

Consumer loans
18

 

 
152

 

 
66

 
1

 
216

 

Total
11,522

 
19

 
22,141

 
1

 
17,193

 
90

 
22,460

 
291

With allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
5,314

 
8

 
3,885

 
59

 
3,865

 
24

 
5,082

 
457

Commercial real estate loans – owner occupied

 

 
795

 

 

 

 
1,203

 

Total
5,314

 
8

 
4,680

 
59

 
3,865

 
24

 
6,285

 
457

Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
13,861

 
27

 
18,441

 
60

 
17,493

 
113

 
17,934

 
736

Commercial real estate loans – owner occupied
1,164

 

 
3,352

 

 
1,653

 

 
3,611

 
3

Commercial real estate loans – all other
1,613

 

 
3,757

 

 
1,650

 

 
5,090

 

Residential mortgage loans – multi-family

 

 
430

 

 

 

 
437

 

Residential mortgage loans – single family
180

 

 
119

 

 
196

 

 
369

 
9

Construction and land development loans

 

 
570

 

 

 

 
1,088

 

Consumer loans
18

 

 
152

 

 
66

 
1

 
216

 

Total
$
16,836

 
$
27

 
$
26,821

 
$
60

 
$
21,058

 
$
114

 
$
28,745

 
$
748

The interest that would have been earned had the impaired loans remained current in accordance with their original terms was $210 thousand and $52 thousand during the three months ended September 30, 2017 and 2016, respectively, and $563 thousand and $827 thousand during the nine months ended September 30, 2017 and 2016, respectively.
Troubled Debt Restructurings (“TDRs”)
Pursuant to the FASB's ASU No. 2011-2, A Creditor’s Determination of whether a Restructuring is a Troubled Debt Restructuring, the Bank's TDRs totaled $1.6 million and $8.9 million at September 30, 2017 and December 31, 2016, respectively. TDRs consist of loans to which modifications have been made for the purpose of alleviating temporary impairments of the borrower's financial condition and cash flows. Those modifications have come in the forms of changes in amortization terms, reductions in interest rates, interest only payments and, in limited cases, concessions to outstanding loan balances. The modifications are made as part of workout plans we enter into with the borrower that are designed to provide a bridge for the borrower’s cash flow shortfalls in the near term. If a borrower works through the near term issues, then in most cases, the original contractual terms of the borrower’s loan will be reinstated.
Of the $1.6 million of TDRs outstanding at September 30, 2017, $489 thousand were performing in accordance with their terms and accruing interest. Our impairment analysis determined no specific reserves were required on the TDR balances outstanding at September 30, 2017.

24


The following table presents loans restructured as TDRs during the three and nine months ended September 30, 2017 and 2016:
 
Three Months Ended
 
September 30, 2017
 
September 30, 2016
(Dollars in thousands)
Number of
Loans
 
Pre-Modification
Outstanding
Recorded
Investment
 
Post-Modification
Outstanding
Recorded
Investment
 
Number of
loans
 
Pre-Modification
Outstanding
Recorded
Investment
 
Post-Modification
Outstanding
Recorded
Investment
Performing
 
 
 
 
 
 
 
 
 
 
 
Commercial loans

 
$

 
$

 

 
$

 
$

 

 

 

 

 

 

Nonperforming
 
 
 
 
 
 
 
 
 
 
 
Commercial loans

 

 

 

 

 

 

 

 

 

 

 

Total Troubled Debt Restructurings(1)

 
$

 
$

 

 
$

 
$

 
Nine Months Ended
 
September 30, 2017
 
September 30, 2016
(Dollars in thousands)
Number of
loans
 
Pre-Modification
Outstanding
Recorded
Investment
 
Post-Modification
Outstanding
Recorded
Investment
 
Number of
loans
 
Pre-Modification
Outstanding
Recorded
Investment
 
Post-Modification
Outstanding
Recorded
Investment
Performing
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
1

 
$
489

 
$
489

 

 
$

 
$

Consumer loans

 

 

 

 

 

 
1

 
489

 
489

 

 

 

Nonperforming
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
2

 
1,739

 
1,101

 

 

 

 
2

 
1,739

 
1,101

 

 

 

Total Troubled Debt Restructurings(1)
3

 
$
2,228

 
$
1,590

 

 
$

 
$

 
(1)
No outstanding loans were restructured during the three months ended September 30, 2017 or 2016 or the nine months ended September 30, 2016. The one loan that was restructured during the first quarter of 2016 was paid off during the third quarter of 2016.
During the three and nine months ended September 30, 2017 and 2016, TDRs that were modified within the preceding 12-month period which subsequently defaulted were as follows:
 
Three Months Ended
 
Nine Months Ended
 
September 30, 2017
 
September 30, 2016
 
September 30, 2017
 
September 30, 2016
 
Number of loans
 
Recorded Investment
 
Number of loans
 
Recorded Investment
 
Number of loans
 
Recorded Investment
 
Number of loans
 
Recorded Investment
 
(Dollars in thousands)
Commercial loans

 
$

 

 
$

 

 
$

 
1

 
$
57

Commercial real estate - owner occupied

 
$

 

 
$

 

 
$

 
1

 
$
761

Total(1)

 
$

 

 
$

 

 
$

 
2

 
$
818

 
(1)
During the three and nine months ended September 30, 2017 and the three months ended September 30, 2016, there were no TDRs that were modified within the preceding 12-month period which subsequently defaulted.


25


6. Income Taxes
For the three and nine months ended September 30, 2017, we had income tax expense of $37 thousand and $150 thousand, respectively. The income tax expense for the three and nine months ended September 30, 2017 represents the payment to the State of California for the cost of doing business within the state and an estimated alternative minimum tax payment. No additional income tax expense was recorded as a result of our net operating loss carryforward. Accounting rules specify that management must evaluate the deferred tax asset on a recurring basis to determine whether enough positive evidence exists to determine whether it is more-likely-than-not that the deferred tax asset will be available to offset or reduce future taxes. Negative evidence included the net loss incurred in 2016, a cumulative three-year loss position, and our accumulated deficit. Positive evidence included our net income for the three and nine months ended September 30, 2017, a decrease in our nonperforming assets from December 31, 2016, the forecast of our taxable income, the time period in which we have to utilize our deferred tax asset and the current economic conditions. The tax code allows net operating losses to be carried forward for 20 years from the date of the loss, and while management believes that the Company will be able to realize the deferred tax asset within that period, we are unable to assert the timing as to when that realization will occur. As a result of this conclusion and due to the hierarchy of evidence that the accounting rules specify, management determined that the valuation allowance of $21.7 million that was previously established on the balance of our deferred tax asset was still required at September 30, 2017.
For the three and nine months ended September 30, 2016, we had an income tax expense of $20.4 million and $17.0 million, respectively, as a result of the establishment of a full valuation allowance during the three months ended September 30, 2016 on the balance of our deferred tax asset, which includes current and historical losses that may be used to offset taxes on future profits. Negative evidence included the significant losses incurred during the second and third quarters of 2016, an increase in our nonperforming assets from December 31, 2015 to September 30, 2016, a cumulative three-year loss position, and our accumulated deficit. Positive evidence included our forecast of our taxable income, the time period in which we have to utilize our deferred tax asset and the current economic conditions. While management believed that the Company would be able to realize the deferred tax asset within the period that our net operating losses may be carried forward, we were unable to assert the timing as to when that realization would occur. As a result of this conclusion and due to the hierarchy of evidence that the accounting rules specify, a valuation allowance was recorded as of September 30, 2016 to offset the deferred tax asset.
We file income tax returns with the U.S. federal government and the State of California. As of September 30, 2017, we were subject to examination by the Internal Revenue Service with respect to our U.S. federal tax returns for the 2014 to 2016 tax years and the Franchise Tax Board for California state income tax returns for the 2012 to 2015 tax years. Net operating losses on our U.S. federal and California state income tax returns may be carried forward 20 years. As of September 30, 2017, we do not believe there will be any material adverse changes in our unrecognized tax benefits over the next 12 months.
Our policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of tax expense. We did not have any accrued interest or penalties associated with any unrecognized tax benefits, and no interest expense was recognized during the three and nine months ended September 30, 2017 or 2016.
7. Stock-Based Employee Compensation Plans
In May 2010, our shareholders approved the adoption of our 2010 Equity Incentive Plan (the “2010 Incentive Plan”), which authorized and set aside a total of 400,000 shares of our common stock for issuance on the exercise of stock options or the grant of restricted stock or other equity incentives to our officers, and other key employees and directors. An additional 158,211 shares of common stock were also set aside which was equal to the total of the shares that were available for the grant of equity incentives under our shareholder-approved 2008 and 2004 Equity Incentive Plans (the “Previously Approved Plans”) at the time of the adoption of the 2010 Incentive Plan. Options to purchase a total of 174,936 shares of our common stock granted under the Previously Approved Plans were outstanding at September 30, 2017. The 2010 Incentive Plan provides that if any of these outstanding options under the Previously Approved Plans expire or are terminated for any reason, then the number of shares that would become available for grants or awards of equity incentives under the 2010 Incentive Plan would be increased by an equivalent number of shares. At the Annual Shareholders meeting held in May 2013, our shareholders approved an additional 800,000 share increase in the maximum number of shares of our common stock that may be issued pursuant to grants or exercises of options or restricted shares or other equity incentives under the 2010 Incentive Plan, of which 243,633 shares of restricted stock, net of shares withheld for taxes, have vested as of September 30, 2017 thereby decreasing the maximum number of shares authorized under the 2010 Incentive Plan. As a result, as of September 30, 2017, the maximum number of shares that were authorized for the grant of options or other equity incentives under the 2010 Incentive Plan totaled 1,289,514 (assuming that all 174,936 shares of our common stock subject to options under the Previously Approved Plans expire or are terminated), or approximately 6% of the shares of our common stock then outstanding.
A stock option entitles the recipient to purchase shares of our common stock at a price per share that may not be less than 100% of the fair market value of the Company’s shares on the date the option is granted. Restricted shares may be granted at such purchase prices and on such other terms, including restrictions and Company repurchase or reacquisition rights, as are fixed by the Compensation Committee at the time rights to purchase such restricted shares are granted. Stock Appreciation Rights (“SARs”)

26


entitle the recipient to receive a cash payment in an amount equal to the difference between the fair market value of the Company’s shares on the date of vesting and a “base price” (which, in most cases, will be equal to the fair market value of the Company’s shares on the date the SAR is granted), subject to the right of the Company to make such payment in shares of its common stock at their then fair market value. Options, restricted shares and SARs may vest immediately or in installments over various periods generally ranging up to five years, subject to the recipient’s continued employment or service or the achievement of specified performance goals, as determined by the Compensation Committee at the time it grants or awards the options, the restricted shares or the SARs. Stock options and SARs may be granted for terms of up to 10 years after the date of grant, but will terminate sooner upon or shortly after a termination of service occurring prior to the expiration of the term of the option or SAR. The Company will become entitled to repurchase any unvested restricted shares, at the same price that was paid for the shares by the recipient, or to cancel those shares in the event of a termination of employment or service of the holder of such shares or if any performance goals specified in the award are not satisfied. To date, the Company has not granted any SARs.
Under FASB ASC 718-10, we are required to recognize, in our financial statements, the fair value of the options or any restricted shares that we grant as compensation cost over their respective service periods. The fair values of the options that were outstanding at September 30, 2017 under the 2010 Incentive Plan were estimated as of their respective dates of grant using the Black-Scholes option-pricing model. The Company, under the 2010 Incentive Plan, granted restricted stock for the benefit of its employees and directors. These restricted shares vest over a period of three years for employees and one year for directors. The recipients of restricted shares have the right to vote all shares subject to such grant and receive all dividends with respect to such shares whether or not the shares have vested. The recipients do not pay any cash consideration for the shares.
Stock Options
The table below summarizes the weighted average assumptions used to determine the fair values of the options granted during the following periods:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Assumptions with respect to:
2017(1)
 
2016(1)
 
2017
 
2016
Expected volatility
%
 
%
 
33
%
 
38
%
Risk-free interest rate
%
 
%
 
1.95
%
 
1.60
%
Expected dividends
%
 
%
 
%
 
%
Expected term (years)
0.0

 
0.0

 
5.7

 
6.3

Weighted average fair value of options granted during period
$

 
$

 
$
2.81

 
$
2.81

 
(1)    No stock options were issued during the three months ended September 30, 2017 or 2016.
The following table summarizes the stock option activity under the Company’s equity incentive plans during the nine months ended September 30, 2017 and 2016, respectively.
 
Number of
Shares
 
Weighted-
Average
Exercise
Price
Per Share
 
Number of
Shares
 
Weighted-
Average
Exercise
Price
Per Share
 
2017
 
2016
Outstanding – January 1,
1,066,914

 
$
6.35

 
838,696

 
$
6.20

Granted
3,000

 
8.05

 
379,551

 
6.92

Exercised
(172,584
)
 
5.77

 
(97,292
)
 
4.66

Forfeited/Canceled
(68,176
)
 
7.06

 
(66,385
)
 
9.48

Outstanding – September 30,
829,154

 
6.42

 
1,054,570

 
6.40

Options Exercisable – September 30,
570,915

 
$
6.19

 
609,970

 
$
6.03

Options Vested – September 30,
570,915

 
$
6.19

 
609,970

 
$
6.03

Options to purchase 20,500 and 14,134 shares of our common stock were exercised during the three months ended September 30, 2017 and 2016, respectively. Options to purchase 172,584 and 97,292 shares of our common stock were exercised during the nine months ended September 30, 2017 and 2016, respectively. The aggregate intrinsic value of options exercised during the three months ended September 30, 2017 and 2016 was $85 thousand and $9 thousand, respectively. The aggregate intrinsic value of options exercised during the nine months ended September 30, 2017 and 2016 was $310 thousand and $249 thousand, respectively. The fair value of options that vested during the three months ended September 30, 2017 and 2016 was $10

27


thousand and $156 thousand, respectively. The fair value of options that vested during the nine months ended September 30, 2017 and 2016 was $400 thousand and $311 thousand, respectively.
The following table provides additional information regarding the vested and unvested options that were outstanding at September 30, 2017.
Options Outstanding as of September 30, 2017
 
Options Exercisable
as of September 30, 2017(1)
 
Vested
 
Unvested
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Remaining
Contractual
Life (Years)
 
Shares
 
Weighted
Average
Exercise Price
$2.97 – $3.99
51,003

 

 
$
3.50

 
3.01
 
51,003

 
$
3.50

$4.00 – $4.99
16,000

 

 
4.34

 
3.55
 
16,000

 
4.34

$5.00– $5.99
30,000

 

 
5.30

 
5.72
 
30,000

 
5.30

$6.00– $6.99
394,752

 
162,693

 
6.59

 
6.75
 
394,752

 
6.51

$7.00-$8.06
79,160

 
95,546

 
7.10

 
8.00
 
79,160

 
7.09

 
570,915

 
258,239

 
$
6.42

 
6.69
 
570,915

 
$
6.19

 
(1)
The weighted average remaining contractual life of the options that were exercisable as of September 30, 2017 was 5.98 years.
The aggregate intrinsic value of options that were outstanding and exercisable under the 2010 Incentive Plan at September 30, 2017 and December 31, 2016 was $1.7 million and $837 thousand, respectively.
 
A summary of the status of the unvested options outstanding as of September 30, 2017 and 2016, and changes in the weighted average grant date fair values of the unvested options during the nine months ended September 30, 2017 and 2016, are set forth in the following table.
 
For the nine months ended September 30,
 
2017
 
2016
 
Number of
Shares Subject
to Options
 
Weighted
Average
Grant Date
Fair Value
 
Number of
Shares Subject
to Options
 
Weighted
Average
Grant Date
Fair Value
Unvested at the beginning of the period
461,944

 
$
2.79

 
215,926

 
$
2.93

Granted
3,000

 
2.81

 
379,551

 
2.76

Vested
(141,329
)
 
2.83

 
(108,820
)
 
2.86

Forfeited/Canceled
(65,376
)
 
2.67

 
(42,057
)
 
2.90

Unvested at the end of the period
258,239

 
2.80

 
444,600

 
2.80

At September 30, 2017, the weighted average period over which nonvested awards were expected to be recognized was 1.75 years.
Restricted Stock
The following table summarizes the activity related to restricted stock granted, vested and forfeited under our equity incentive plans during the nine months ended September 30, 2017 and 2016.
 
For the nine months ended September 30,
 
2017
 
2016
 
Number of Shares
 
Average Grant Date Fair Value
 
Number of Shares
 
Average Grant Date Fair Value
Outstanding at the beginning of the period
151,298

 
$
6.84

 
129,283

 
$
6.75

Granted
29,907

 
7.69

 
113,975

 
6.82

Vested
(69,107
)
 
6.81

 
(65,075
)
 
6.70

Forfeited
(18,509
)
 
6.82

 
(30,585
)
 
6.63

Outstanding at the end of the period
93,589

 
$
7.14

 
147,598

 
$
6.85


28


Compensation Expense
We expect that the compensation expense that will be recognized during the periods presented below in respect of stock options and restricted stock outstanding at September 30, 2017, will be as follows:
 
Estimated Stock Based Compensation Expense Stock Options
 
Estimated Stock Based Compensation Expense Restricted Stock
 
Estimated Stock Based Compensation Expense Total
(Dollars in thousands)
 
 
 
 
 
For the years ending December 31,
 
 
 
 
 
Remainder of 2017
$
94

 
$
111

 
$
205

2018
317

 
194

 
511

2019
67

 
53

 
120

2020
21

 
29

 
50

2021 and beyond
11

 
23

 
34

 
$
510

 
$
410

 
$
920

The aggregate amounts of stock based compensation expense recognized in our consolidated statements of operations for the three months ended September 30, 2017 and 2016 were $188 thousand and $254 thousand, respectively, in each case net of taxes. The aggregate amounts of stock based compensation expense recognized in our consolidated statements of operations for the nine months ended September 30, 2017 and 2016 were $593 thousand and $807 thousand, respectively, in each case net of taxes.

8. Earnings Per Share (“EPS”)
Basic EPS excludes dilution and is computed by dividing net income or loss available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if stock options or other contracts to issue common stock were exercised or converted into common stock that would then share in our earnings.

The following table shows how we computed basic and diluted EPS for the three and nine months ended September 30, 2017 and 2016. 
(In thousands, except per share data)
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
2017
 
2016
 
2017
 
2016
Numerator:
 
 
 
 
 
 
 
Numerator for basic and diluted net income (loss) available to common shareholders
$
3,756

 
$
(30,526
)
 
$
8,037

 
$
(34,952
)
Denominator:
 
 
 
 
 
 
 
Basic weighted average outstanding shares of common stock
23,193

 
22,996

 
23,173

 
22,944

Dilutive effect of employee stock options
138

 

 
117

 

Diluted weighted average common stock and common stock equivalents
23,331

 
22,996

 
23,290

 
22,944

Basic income (loss) per common share:
 
 
 
 
 
 
 
Net income (loss) available to common shareholders
$
0.16

 
$
(1.33
)
 
$
0.35

 
$
(1.52
)
Diluted income (loss) per common share:
 
 
 
 
 
 
 
Net income (loss) available to common shareholders
$
0.16

 
$
(1.33
)
 
$
0.35

 
$
(1.52
)
The weighted average shares that have an antidilutive effect in the calculation of diluted net income per share and have been excluded from the computations above were as follows:
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
Stock options(1)(2)
129,431

 
1,059,834

 
357,859

 
1,031,065

 
(1)
Stock options were excluded from the computation of diluted earnings per common share for the three and nine months ended September 30, 2017 as a result of the shares being “out-of-the-money.”
(2)
Stock options were excluded from the computation of diluted earnings per common share for the three and nine months ended September 30, 2016 as we reported a net loss available to common shareholders.

29



9. Shareholders’ Equity
Accumulated Other Comprehensive Income (Loss), net
Accumulated other comprehensive income (loss), net as of September 30, 2017 and December 31, 2016 was as follows:
 
Unrealized Gain (Loss) on Securities Available-for-Sale, net of tax
 
Accumulated Other Comprehensive Income (Loss), Net
 
(Dollars in thousands)
Ending balance as of December 31, 2015
$
(810
)
 
$
(810
)
Other comprehensive income before reclassifications, net of tax provision of $739 thousand (1)
(1,032
)
 
(1,032
)
Amounts reclassified from accumulated other comprehensive loss, net of tax

 

Other comprehensive income, net of tax provision of $739 thousand
(1,032
)
 
(1,032
)
Ending balance as of December 31, 2016
$
(1,842
)
 
$
(1,842
)
Other comprehensive income before reclassifications(2)
914

 
914

Amounts reclassified from accumulated other comprehensive income, net of tax

 

Other comprehensive income(2)
914

 
914

Ending balance as of September 30, 2017
$
(928
)
 
$
(928
)
 
(1)
Tax impact included in Deferred tax assets.
(2)
No tax impact as a result of the full valuation allowance recorded against our deferred tax asset at September 30, 2017.
10. Commitments and Contingencies
Repurchase Reserves
We have historically maintained reserves for possible repurchases that we may have been required to make of certain of the mortgage loans which we sold as a result of deficiencies or defects that may be found to exist in such loans. Our repurchase reserve also covered returns of any premiums earned and administrative fees pertaining to the repurchase of mortgage loans that did not meet investor guidelines, including potential loss of advances on Veterans Affairs or Federal Housing Authority Ginnie Mae loans.  As a result of our exit from the mortgage banking business and no longer being subject to potential loss for anything other than mortgage fraud, we have undertaken an analysis of our accrual. Our original analysis assumed that the repurchase liability exposure would decrease over time as mortgage loans were paid off and as we were no longer originating new mortgage loans. During the three months ended September 30, 2017, management’s analysis determined that there was no risk that we would be required to repurchase loans sold at a loss. Therefore, management made the determination to reverse the remaining reserve of $241 thousand during the three months ended September 30, 2017. No loans were repurchased during the three and nine months ended September 30, 2017 or during the three and nine months ended September 30, 2016. The following table sets forth information at September 30, 2017 and December 31, 2016, with respect to our repurchase reserves:
 
At and For the Nine Months Ended
 
At and For the Year Ended
 
September 30, 2017
 
December 31, 2016
 
(Dollars in thousands)
Beginning balance
$
254

 
$
314

Recovery of repurchases
(254
)
 
(60
)
Settlements

 

Total repurchases reserve
$

 
$
254

Commitments
To meet the financing needs of our customers in the normal course of business, we are a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. At September 30, 2017 and December 31, 2016, we were committed to fund certain loans including letters of credit amounting to approximately $323 million and $317 million, respectively. The contractual amounts of a

30


credit-related financial instrument, such as a commitment to extend credit, a credit-card arrangement or a letter of credit, represent the amount of potential accounting loss should the commitment be fully drawn upon, the customer were to default, and the value of any existing collateral securing the customer’s payment obligation becomes worthless. The loss reserve for unfunded loan commitments was $350 thousand at both September 30, 2017 and December 31, 2016.
As a result, we use the same credit policies in making commitments to extend credit and conditional obligations as we do for on-balance sheet instruments. Commitments generally have fixed expiration dates; however, since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis, using the same credit underwriting standards that are employed in making commercial loans. The amount of collateral obtained, if any, upon an extension of credit is based on our evaluation of the creditworthiness of the customer. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, residential real estate and income-producing commercial properties.
Borrowings
As of September 30, 2017, we had $15.0 million of outstanding borrowings from the FHLB. These borrowings matured and were repaid on October 2, 2017. The interest rate on these borrowings was 1.14%.
Litigation, Claims and Assessments
We are a defendant in or a party to a number of legal actions or proceedings that arise in the ordinary course of business. In some of these actions and proceedings, claims for monetary damages are asserted against us.
In accordance with applicable accounting guidance, we establish an accrued liability for lawsuits or other legal proceedings when they present loss contingencies that are both probable and estimable. We estimate any potential loss based upon currently available information and significant judgments and a variety of assumptions, and known and unknown uncertainties. Moreover, the facts and circumstances on which such estimates are based will change over time. Therefore, the amount of any losses we might incur in any lawsuits or other legal proceedings may exceed amounts which we had accrued based on our estimates and those estimates do not represent the maximum loss exposure that we may have in connection with any lawsuits or other legal proceedings.
In December 2016, following an ongoing review related to alleged discriminatory practices within our discontinued mortgage banking business, we received notice that the U.S. Department of Justice has authorized a potential enforcement action against the Bank. We are in discussions with the U.S. Department of Justice to settle this matter. While we believe that we have meritorious defenses against any potential claim, the ultimate resolution of the matter is unknown. Based on current knowledge, however, we believe that the amount or range of loss with respect to this matter will not have a material impact to our consolidated financial position, results of operations or cash flows.
Based on our evaluation of the remaining lawsuits and other proceedings that were pending against us as of September 30, 2017, the outcomes in those suits or other proceedings are not expected to have, either individually or in the aggregate, a material adverse effect on our consolidated financial position, results of operations or cash flows. However, in light of the inherent uncertainties involved, some of which are beyond our control, and the very large or indeterminate damages often sought in such legal actions or proceedings, an adverse outcome in one or more of these suits or proceedings could be material to our results of operations or cash flows for any particular reporting period.

11. Business Segment Information
We have one reportable business segment, commercial banking. The commercial banking segment provides small and medium-size businesses, professional firms and individuals with a diversified range of products and services such as various types of deposit accounts, various types of commercial and consumer loans, cash management services, and online banking services.
Since our operating segment derives all of its revenues from interest and noninterest income and interest expense constitutes its most significant expense, this segment is reported below using net interest income (interest income less interest expense) and noninterest income (primarily net gains on sales of small business administration loans and fee income). We do not allocate general and administrative expenses or income taxes to our operating segment.

31


The following table sets forth information regarding the net interest income and noninterest income for our commercial banking segment for the three and nine months ended September 30, 2017 and 2016.
(Dollars in thousands)
Commercial
 
Other(1)
 
Total
Net interest income for the three months ended September 30,
 
 
 
 
 
2017
$
11,038

 
$
967

 
$
12,005

2016
$
9,310

 
$
(121
)
 
$
9,189

Noninterest income for the three months ended September 30,
 
 
 
 
 
2017
$
959

 
$
5

 
$
964

2016
$
1,049

 
$
5

 
$
1,054

Net interest income for the nine months ended September 30,
 
2017
$
31,564

 
$
908

 
$
32,472

2016
$
26,776

 
$
(403
)
 
$
26,373

Noninterest income for the nine months ended September 30,
 
 
 
 
 
2017
$
2,944

 
$
420

 
$
3,364

2016
$
2,649

 
$
22

 
$
2,671

Segment Assets at:
 
 
 
 
 
September 30, 2017
$
1,202,723

 
$
2,238

 
$
1,204,961

December 31, 2016
$
1,126,890

 
$
13,799

 
$
1,140,689

 
(1)
Represents net interest income and noninterest income for PMAR and PMBC.

32


12. Regulatory Capital
Under federal banking regulations that apply to all United States based bank holding companies and federally insured banks, the Company (on a consolidated basis) and the Bank (on a stand-alone basis) must meet specific capital adequacy requirements that, for the most part, involve quantitative measures, primarily in terms of the ratios of their capital to their assets, liabilities, and certain off-balance sheet items, calculated under regulatory accounting practices. Under those regulations, each bank holding company must meet a minimum capital ratio and each federally insured bank is determined by its primary federal bank regulatory agency to come within one of the following capital adequacy categories on the basis of its capital ratios:
well-capitalized
adequately capitalized
undercapitalized
significantly undercapitalized; or
critically undercapitalized
Certain qualitative assessments also are made by a banking institution’s primary federal regulatory agency that could lead the agency to determine that the banking institution should be assigned to a lower capital category than the one indicated by the quantitative measures used to assess the institution’s capital adequacy. At each successive lower capital category, a banking institution is subject to greater operating restrictions and increased regulatory supervision by its federal bank regulatory agency.
The following table sets forth the capital and capital ratios of the Company (on a consolidated basis) and the Bank (on a stand-alone basis) at September 30, 2017, as compared to the respective regulatory requirements applicable to them.
 
 
 
 
 
 
Applicable Federal Regulatory Requirement
 
 
 
For Capital
Adequacy Purposes
 
To be Categorized As
Well-Capitalized
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
 
(Dollars in thousands)
Total Capital to Risk Weighted Assets:
 
 
 
 
 
 
 
 
 
 
 
Company
$
142,421

 
12.2
%
 
$
100,550

 
At least 8.625
 
N/A

 
N/A
Bank
134,355

 
11.6
%
 
100,370

 
At least 8.625
 
$
116,371

 
At least 10.0
Common Equity Tier 1 Capital to Risk Weighted Assets:
 
 
 
 
 
 
 
 
 
 
 
Company
$
110,839

 
9.5
%
 
$
59,747

 
At least 5.125
 
N/A

 
N/A
Bank
119,799

 
10.3
%
 
59,640

 
At least 5.125
 
$
75,641

 
At least 6.5
Tier 1 Capital to Risk Weighted Assets:
 
 
 
 
 
 
 
 
 
 
 
Company
$
127,839

 
11.0
%
 
$
77,234

 
At least 6.625
 
N/A

 
N/A
Bank
119,799

 
10.3
%
 
77,095

 
At least 6.625
 
$
93,096

 
At least 8.0
Tier 1 Capital to Average Assets:
 
 
 
 
 
 
 
 
 
 
 
Company
$
127,839

 
10.8
%
 
$
47,387

 
At least 4.0
 
N/A

 
N/A
Bank
119,799

 
10.2
%
 
47,174

 
At least 4.0
 
$
58,967

 
At least 5.0
In early July 2013, the Federal Reserve Board and the FDIC issued final rules implementing the Basel III regulatory capital framework and related Dodd-Frank Wall Street Reform and Consumer Protection Act changes. The rules revise minimum capital requirements and adjust prompt correct action thresholds.  The final rules revise the regulatory capital elements, add a new common equity Tier 1 capital ratio, increase the minimum Tier 1 capital ratio requirement, and implement a new capital conservation buffer. The rules also permit certain banking organizations to retain, through a one-time election, the existing treatment for accumulated other comprehensive income. The final rules took effect for community banks on January 1, 2015, subject to a transition period for certain parts of the rules. At September 30, 2017, the Bank (on a stand-alone basis) continued to qualify as a well-capitalized institution, and the Company continued to exceed the minimum required capital ratios applicable to it, under the capital adequacy guidelines described above.

ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward Looking Statements

33


Statements contained in this Quarterly Report on Form 10-Q (this “Report”) that are not historical facts or that discuss our expectations, beliefs or views regarding our future operations or future financial performance, or financial or other trends in our business or in the markets in which we operate, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “project,” "forecast," or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.” The information contained in such forward-looking statements is based on current information available to us and on assumptions that we make about future economic and market conditions and other events over which we do not have control. In addition, our business and the markets in which we operate are subject to a number of risks and uncertainties. Such risks and uncertainties, and the occurrence of events in the future or changes in circumstances that had not been anticipated, could cause our financial condition or actual operating results in the future to differ materially from our expected financial condition or operating results that are set forth in the forward-looking statements contained in this Report and could, therefore, also affect the price performance of our shares.
In addition to the risk of incurring loan losses and provision for loan losses, which is an inherent risk of the banking business, these risks and uncertainties include, but are not limited to, the following: the risk that the credit quality of our borrowers declines; potential declines in the value of the collateral for secured loans; the risk that steps we have taken to strengthen our overall credit administration are not effective; the risk of a downturn in the United States economy, and domestic or international economic conditions, which could cause us to incur additional loan losses and adversely affect our results of operations in the future; the risk that our interest margins and, therefore, our net interest income will be adversely affected by changes in prevailing interest rates; the risk that we will not succeed in further reducing our remaining nonperforming assets, in which event we would face the prospect of further loan charge-offs and write-downs of assets; the risk that we will not be able to manage our interest rate risks effectively, in which event our operating results could be harmed; the prospect of changes in government regulation of banking and other financial services organizations, which could impact our costs of doing business and restrict our ability to take advantage of business and growth opportunities; the risk that our efforts to develop a robust commercial banking platform may not succeed; and the risk that we may be unable to realize our expected level of increasing deposit inflows. Readers of this Report are encouraged to review the additional information regarding these and other risks and uncertainties to which our business is subject that is contained in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2016 (the “2016 Form 10-K”) that we filed with the Securities and Exchange Commission (“SEC”) on March 10, 2017, as such information may be updated from time to time in subsequent Quarterly Reports on Form 10-Q that we file with the SEC. We urge you to read those risk factors in conjunction with your review of the following discussion and analysis of our results of operations for the three and nine months ended, and our financial condition at, September 30, 2017.
Due to the risks and uncertainties we face, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Report, which speak only as of the date of this Report, or to make predictions about future performance based solely on historical financial performance. We also disclaim any obligation to update forward-looking statements contained in this Report as a result of new information, future events or otherwise, except as may otherwise be required by law.

Overview
The following discussion presents information about our consolidated results of operations, financial condition, liquidity and capital resources and should be read in conjunction with our consolidated financial statements and the notes thereto included in Item 1 above of this Report.
Our principal operating subsidiary is Pacific Mercantile Bank (the “Bank”), which is a California State chartered bank. The Bank accounts for substantially all of our consolidated revenues, expenses and income and our consolidated assets and liabilities. Accordingly, the following discussion focuses primarily on the Bank’s results of operations and financial condition.
As of September 30, 2017, our total assets, net loans and total deposits were $1.2 billion, $1.0 billion and $1.1 billion, respectively.
The Bank, which is headquartered in Orange County, California, approximately 40 miles south of Los Angeles, conducts a commercial banking business in Orange, Los Angeles, San Bernardino and San Diego counties in Southern California. The Bank is also a member of the Federal Reserve System and its deposits are insured, to the maximum extent permitted by law, by the Federal Deposit Insurance Corporation (the “FDIC”). For the nine months ended September 30, 2017 and 2016, we operated as one reportable segment, Commercial Banking.
Unless the context otherwise requires, the “Company,” “we,” “our,” “ours,” and “us” refer to Pacific Mercantile Bancorp and its consolidated subsidiaries.

34


    
Results of Operations
Operating Results for the Three and Nine Months Ended September 30, 2017 and 2016     
Our operating results for the three and nine months ended September 30, 2017, compared to the same period in September 30, 2016, were as follows:
 
Three Months Ended September 30,
 
2017 vs. 2016
% Change
 
Nine Months Ended September 30,
 
2017 vs. 2016
% Change
 
2017
 
2016
 
 
2017
 
2016
 
 
(Dollars in thousands)
Interest income
$
14,025

 
$
10,598

 
32.3
 %
 
$
37,761

 
$
30,388

 
24.3
 %
Interest expense
2,020

 
1,409

 
43.4
 %
 
5,289

 
4,015

 
31.7
 %
Provision for loan and lease losses

 
10,730

 
(100.0
)%
 

 
19,870

 
(100.0
)%
Non-interest income
964

 
1,054

 
(8.5
)%
 
3,364

 
2,671

 
25.9
 %
Non-interest expense
9,176

 
9,687

 
(5.3
)%
 
27,649

 
27,135

 
1.9
 %
Income tax expense
37

 
20,352

 
(99.8
)%
 
150

 
16,991

 
(99.1
)%
Net income
3,756

 
(30,526
)
 
(112.3
)%
 
8,037

 
(34,952
)
 
(123.0
)%
Interest Income
Three Months Ended September 30, 2017 and 2016
Total interest income increased 32.3% to $14.0 million for the three months ended September 30, 2017 from $10.6 million for the three months ended September 30, 2016. This was primarily due to an increase in interest income on loans and short-term investments during the three months ended September 30, 2017 as compared to the same prior year period. During the three months ended September 30, 2017 and 2016, interest income on loans was $13.4 million and $10.0 million, respectively, yielding 5.21% and 4.64% on average loan balances of $1.0 billion and $857.8 million, respectively. The increase in the average loan balances is attributable to an increase in loan demand during the three months ended September 30, 2017. The increase in average loan yield is primarily attributable to the Board of Governors of the Federal Reserve System (“Federal Reserve Board”) raising short-term interest rates by 75 basis points since the fourth quarter of 2016 and the recovery of $1.1 million in interest income on one loan relationship that paid off during the quarter which was on nonaccrual status.
During the three months ended September 30, 2017 and 2016, interest income from our securities available-for-sale and stock was $304 thousand and $356 thousand, respectively, yielding 2.46% and 2.51% on average balances of $49.0 million and $56.5 million, respectively. The average securities balances decreased as a result of maturities of, and payments on, securities which we did not fully replace. Interest income from our short-term investments, including our federal funds sold and interest-bearing deposits, was $335 thousand and $244 thousand for the three months ended September 30, 2017 and 2016, respectively, yielding 1.27% and 0.51% on average balances of $105.0 million and $189.0 million, respectively. The increase in interest income from our short-term investments was primarily attributable to an increase in the average yield during the three months ended September 30, 2017 as compared to the three months ended September 30, 2016. The increase in the average yield is attributable to the Federal Reserve Board raising interest rates by 75 basis points since the fourth quarter of 2016. As a result, total interest income on investments increased for the three months ended September 30, 2017 as compared to the three months ended September 30, 2016.
Nine Months Ended September 30, 2017 and 2016
Total interest income increased 24.3% to $37.8 million for the nine months ended September 30, 2017 from $30.4 million for the nine months ended September 30, 2016. This was primarily due to an increase in interest income on loans and short-term investments during the nine months ended September 30, 2017 as compared to the same prior year period. During the nine months ended September 30, 2017 and 2016, interest income on loans was $35.9 million and $28.7 million, respectively, yielding 4.89% and 4.52% on average loan balances of $981.5 million and $847.8 million, respectively. The increase in the average loan balances is attributable to an increase in loan demand during the nine months ended September 30, 2017. The increase in average loan yield is primarily attributable to the Federal Reserve Board raising short-term interest rates by 75 basis points since the fourth quarter of 2016 and the recovery of $1.1 million in interest income on one loan relationship that paid off during the three months ended September 30, 2017 which was on nonaccrual status.
During the nine months ended September 30, 2017 and 2016, interest income from our securities available-for-sale and stock was $930 thousand and $1.1 million, respectively, yielding 2.49% and 2.46% on average balances of $50.0 million and $58.3 million, respectively. The average securities balances decreased as a result of maturities of, and payments on, securities which we did not fully replace. Interest income from our short-term investments, including our federal funds sold and interest-bearing

35


deposits, was $904 thousand and $613 thousand for the nine months ended September 30, 2017 and 2016, respectively, yielding 1.03% and 0.51% on average balances of $117.1 million and $160.3 million, respectively. The increase in interest income from our short-term investments was primarily attributable to an increase in the average yield during the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016 as a result of the Federal Reserve Board raising interest rates by 75 basis points since the fourth quarter of 2016. As a result, total interest income on investments increased for the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016.

Interest Expense
Three Months Ended September 30, 2017 and 2016
Total interest expense increased 43.4% for the three months ended September 30, 2017 compared to the three months ended September 30, 2016. The increase was primarily due to an increase in our cost of funds from 0.83% at September 30, 2016 to 1.08% at September 30, 2017 and an increase in the average balance of interest-bearing liabilities from $678.7 million at September 30, 2016 to $740.0 million at September 30, 2017, which consisted of deposits, borrowings and junior subordinated debentures. Our cost of funds increased as a result of the actions of the Federal Reserve Board to raise short-term interest rates by 75 basis points since the fourth quarter of 2016. The increase in our average balance of interest-bearing liabilities is primarily attributable to the increase in the average balance of our core deposits as a result of new client acquisitions. Interest expense on our certificates of deposit for the three months ended September 30, 2017 and 2016 was $980 thousand and $679 thousand, respectively, with a cost of funds of 1.28% and 1.01% on average balances of $304.4 million and $267.6 million, respectively.
Nine Months Ended September 30, 2017 and 2016
Total interest expense increased 31.7% for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016. The increase was primarily due to an increase in our cost of funds from 0.80% at September 30, 2016 to 0.97% at September 30, 2017 and an increase in the average balance of interest-bearing liabilities of $671.0 million at September 30, 2016 to $727.0 million at September 30, 2017, which consisted of deposits, borrowings and junior subordinated debentures. Our cost of funds increased as a result of the actions of the Federal Reserve Board to raise short-term interest rates by 75 basis points since the fourth quarter of 2016. The increase in our average balance of interest-bearing liabilities is primarily attributable to the increase in the average balance of our core deposits as a result of new client acquisitions. Interest expense on our certificates of deposit for the nine months ended September 30, 2017 and 2016 was $2.5 million and $1.9 million, respectively, with a cost of funds of 1.18% and 0.97% on average balances of $279.6 million and $264.5 million, respectively.
Net Interest Margin
One of the principal determinants of a bank’s income is its net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest earning assets, on the one hand, and (ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on borrowings and other interest-bearing liabilities, on the other hand. As a general rule, all other things being equal, the greater the difference or “spread” between the amount of our interest income and the amount of our interest expense, the greater will be our net income; whereas, a decline in that difference or “spread” will generally result in a decline in our net income.
A bank’s interest income and interest expense are affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the monetary policies of the Federal Reserve Board which affect interest rates, competition in the market place for loans and deposits, the demand for loans and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organization’s “net interest margin.”
As a result of the Federal Reserve Board raising interest rates by 75 basis points since the fourth quarter of 2016, we experienced expansion in our net interest margin. The favorable impact of higher prevailing interest rates on our asset-sensitive balance sheet was evidenced in the three and nine months ended September 30, 2017. While we are unable to assert as to whether the Federal Reserve Board will continue to increase short-term interest rates in the future, we expect the favorable impact on our net interest margin to remain in the event that interest rates continue to rise.
The following table sets forth information regarding our average balances, yields on interest earning assets, interest expense on interest-bearing liabilities, the interest rate spread and the interest rate margin for the three and nine months ended September 30, 2017 and 2016. Average balances are calculated based on average daily balances.

36


 
Three Months Ended September 30,
 
2017
 
2016
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
(Dollars in thousands)
Interest-earning assets
 
 
 
 
 
 
 
 
 
 
 
Short-term investments(1)
$
104,968

 
$
335

 
1.27
%
 
$
188,982

 
$
244

 
0.51
%
Securities available for sale and stock(2)
49,033

 
304

 
2.46
%
 
56,457

 
356

 
2.51
%
Loans(3)
1,019,253

 
13,386

 
5.21
%
 
857,784

 
9,998

 
4.64
%
Total interest-earning assets
1,173,254

 
14,025

 
4.74
%
 
1,103,223

 
10,598

 
3.82
%
Noninterest-earning assets
 
 
 
 
 
 
 
 
 
 
 
Cash and due from banks
13,801

 
 
 
 
 
14,462

 
 
 
 
All other assets
(2,099
)
 
 
 
 
 
21,784

 
 
 
 
Total assets
$
1,184,956

 
 
 
 
 
$
1,139,469

 
 
 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing checking accounts
$
93,597

 
$
104

 
0.44
%
 
$
57,614

 
$
41

 
0.28
%
Money market and savings accounts
323,825

 
761

 
0.93
%
 
326,666

 
520

 
0.63
%
Certificates of deposit
304,404

 
980

 
1.28
%
 
267,590

 
679

 
1.01
%
Other borrowings
652

 
2

 
1.22
%
 
9,293

 
24

 
1.03
%
Junior subordinated debentures
17,527

 
173

 
3.92
%
 
17,527

 
145

 
3.29
%
Total interest bearing liabilities
740,005

 
2,020

 
1.08
%
 
678,690

 
1,409

 
0.83
%
Noninterest bearing liabilities
 
 
 
 
 
 
 
 
 
 
 
Demand deposits
329,168

 
 
 
 
 
322,768

 
 
 
 
Accrued expenses and other liabilities
7,959

 
 
 
 
 
6,274

 
 
 
 
Shareholders equity
107,824

 
 
 
 
 
131,737

 
 
 
 
Total liabilities and shareholders' equity
$
1,184,956

 
 
 
 
 
$
1,139,469

 
 
 
 
Net interest income
 
 
$
12,005

 
 
 
 
 
$
9,189

 
 
Net interest income/spread
 
 
 
 
3.66
%
 
 
 
 
 
2.99
%
Net interest margin
 
 
 
 
4.06
%
 
 
 
 
 
3.31
%
 
(1)
Short-term investments consist of federal funds sold and interest bearing deposits that we maintain at other financial institutions.
(2)
Stock consists of Federal Home Loan Bank (“FHLB”) stock and Federal Reserve Bank of San Francisco (“FRBSF”) stock.
(3)
Loans include the average balance of nonaccrual loans.

37


 
Nine Months Ended September 30,
 
2017
 
2016
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
(Dollars in thousands)
Interest-earning assets
 
 
 
 
 
 
 
 
 
 
 
Short-term investments(1)
$
117,128

 
$
904

 
1.03
%
 
$
160,346

 
$
613

 
0.51
%
Securities available for sale and stock(2)
50,032

 
930

 
2.49
%
 
58,293

 
1,075

 
2.46
%
Loans(3)
981,504

 
35,927

 
4.89
%
 
847,833

 
28,700

 
4.52
%
Total interest-earning assets
1,148,664

 
37,761

 
4.40
%
 
1,066,472

 
30,388

 
3.81
%
Noninterest-earning assets
 
 
 
 
 
 
 
 
 
 
 
Cash and due from banks
14,297

 
 
 
 
 
15,610

 
 
 
 
All other assets
(1,711
)
 
 
 
 
 
20,057

 
 
 
 
Total assets
$
1,161,250

 
 
 
 
 
$
1,102,139

 
 
 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing checking accounts
$
88,962

 
$
254

 
0.38
%
 
$
54,993

 
$
108

 
0.26
%
Money market and savings accounts
340,464

 
2,080

 
0.82
%
 
324,222

 
1,481

 
0.61
%
Certificates of deposit
279,630

 
2,458

 
1.18
%
 
264,457

 
1,924

 
0.97
%
Other borrowings
399

 
3

 
1.01
%
 
9,785

 
74

 
1.01
%
Junior subordinated debentures
17,527

 
494

 
3.77
%
 
17,527

 
428

 
3.26
%
Total interest bearing liabilities
726,982

 
5,289

 
0.97
%
 
670,984

 
4,015

 
0.80
%
Noninterest bearing liabilities
 
 
 
 
 
 
 
 
 
 
 
Demand deposits
321,808

 
 
 
 
 
290,830

 
 
 
 
Accrued expenses and other liabilities
7,359

 
 
 
 
 
6,156

 
 
 
 
Shareholders’ equity
105,101

 
 
 
 
 
134,169

 
 
 
 
Total liabilities and shareholders' equity
$
1,161,250

 
 
 
 
 
$
1,102,139

 
 
 
 
Net interest income
 
 
$
32,472

 
 
 
 
 
$
26,373

 
 
Net interest income/spread
 
 
 
 
3.43
%
 
 
 
 
 
3.01
%
Net interest margin
 
 
 
 
3.78
%
 
 
 
 
 
3.30
%
 
(1)
Short-term investments consist of federal funds sold and interest bearing deposits that we maintain at other financial institutions.
(2)
Stock consists of Federal Home Loan Bank (“FHLB”) stock and Federal Reserve Bank of San Francisco (“FRBSF”) stock.
(3)
Loans include the average balance of nonaccrual loans.

The following table sets forth changes in interest income, including loan fees, and interest paid in the three and nine months ended September 30, 2017 and 2016 and the extent to which those changes were attributable to changes in (i) the volumes of or the rates of interest earned on interest-earning assets and (ii) the volumes of or the rates of interest paid on our interest-bearing liabilities.
 

38


 
Three Months Ended September 30, 2017 Compared to
Three Months Ended September 30, 2016 Increase (Decrease) due to Changes in
 
Nine Months Ended September 30, 2017 Compared to
Nine Months Ended September 30, 2016 Increase (Decrease) due to Changes in
 
Volume
 
Rates
 
Total Increase
(Decrease)
 
Volume
 
Rates
 
Total
Increase
(Decrease)
 
(Dollars in thousands)
Interest income
 
 
 
 
 
 
 
 
 
 
 
Short-term investments(1)
$
(146
)
 
$
237

 
$
91

 
$
(200
)
 
$
492

 
$
292

Securities available for sale and stock(2)
(45
)
 
(7
)
 
(52
)
 
(154
)
 
9

 
(145
)
Loans
2,045

 
1,343

 
3,388

 
4,748

 
2,479

 
7,227

Total earning assets
1,854

 
1,573

 
3,427

 
4,394

 
2,980

 
7,374

Interest expense
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing checking accounts
33

 
30

 
63

 
84

 
62

 
146

Money market and savings accounts
(5
)
 
246

 
241

 
77

 
522

 
599

Certificates of deposit
103

 
198

 
301

 
115

 
419

 
534

Borrowings
(26
)
 
4

 
(22
)
 
(71
)
 

 
(71
)
Junior subordinated debentures

 
28

 
28

 

 
67

 
67

Total interest-bearing liabilities
105

 
506

 
611

 
205

 
1,070

 
1,275

Net interest income
$
1,749

 
$
1,067

 
$
2,816

 
$
4,189

 
$
1,910

 
$
6,099

 
(1)
Short-term investments consist of federal funds sold and interest bearing deposits that we maintain at financial institutions.
(2)
Stock consists of FHLB stock and FRBSF stock.
Provision for Loan and Lease Losses
We maintain reserves to provide for loan losses that occur in the ordinary course of the banking business. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced (“written down”) to what management believes is its realizable value or, if it is determined that a loan no longer has any realizable value, the carrying value of the loan is written off in its entirety (a loan “charge-off”). Loan charge-offs and write-downs are charged against our allowance for loan and lease losses (“ALLL”). The amount of the ALLL is increased periodically to replenish the ALLL after it has been reduced due to loan write-downs or charge-offs. The ALLL also is increased or decreased periodically to reflect increases or decreases in the volume of outstanding loans and to take account of changes in the risk of probable loan losses due to financial performance of borrowers, the value of collateral securing non-performing loans or changing economic conditions. Increases in the ALLL are made through a “provision for loan and lease losses” that is recorded as an expense in the statement of operations. Increases in the ALLL are also recognized through the recovery of charged-off loans which are added back to the ALLL. As such, recoveries are a direct offset for a provision for loan and lease losses that would otherwise be needed to replenish or increase the ALLL.
We employ economic models and data that conform to bank regulatory guidelines and reflect sound industry practices as well as our own historical loan loss experience to determine the sufficiency of the ALLL and any provisions needed to increase or replenish the ALLL. Those determinations involve judgments and assumptions about current economic conditions and external events that can impact the ability of borrowers to meet their loan obligations. However, the duration and impact of these factors cannot be determined with any certainty. As such, unanticipated changes in economic or market conditions, bank regulatory guidelines or the sound practices that are used to determine the sufficiency of the ALLL, could require us to record additional, and possibly significant, provisions to increase the ALLL. This would have the effect of reducing reportable income or, in the most extreme circumstance, creating a reportable loss. In addition, the Federal Reserve Bank and the California Department of Business Oversight (“CDBO”), as an integral part of their regulatory oversight, periodically review the adequacy of our ALLL. These agencies may require us to make additional provisions for perceived potential loan losses, over and above the provisions that we have already made, the effect of which would be to reduce our income or increase any losses we might incur.
We recorded no provision for loan and lease losses during the three months ended September 30, 2017, as compared to a provision for loan and lease losses of $10.7 million recorded during the three months ended September 30, 2016. There was no provision for the third quarter of 2017 due primarily to reserves for new loan growth being offset by a decline in the level of classified assets. We recorded a $10.7 million provision for loan and lease losses in the third quarter of 2016 due to downgrades and charge-offs on loans that exceeded recoveries during the third quarter of 2016. During the three months ended September 30, 2017, we had net charge-offs of $2.1 million.

39


We recorded no provision for loan and lease losses during the nine months ended September 30, 2017 as compared to a provision for loan and lease losses of $19.9 million recorded during the nine months ended September 30, 2016. We recorded no provision for loan and lease losses during the nine months ended September 30, 2017 due primarily to reserves for new loan growth being offset by a decline in the level of classified assets. We recorded a provision for loan and lease losses of $19.9 million for the nine months ended September 30, 2016 primarily as a result of new loan growth and downgrades and charge-offs on several loans that exceeded recoveries during the nine months ended September 30, 2016.
During the three months ended September 30, 2016, the Company downgraded $48 million in loans as part of a comprehensive credit review. During the year subsequent to September 30, 2016, the Company has received $33.7 million in principal payments, net of advances, on these loans, $5.5 million in loan upgrades have been made and there have been charge-offs of $1.6 million for these loans, accounting for 85% of the total amount of loans downgraded during the third quarter of 2016. The loan upgrades were reviewed and confirmed by third parties during the first half of 2017. The Company anticipates the remaining $7.2 million in loan downgrades taken in the third quarter of 2016 to be reflected in overall collections and credit quality indicators in future reporting periods, and cannot predict the timing as to when these credits will be resolved.
See “—Financial Condition—Nonperforming Assets and Allowance for Loan and Lease Losses” below in this Item 2 for additional information regarding the ALLL.
Noninterest Income
The following table identifies the components of and the percentage changes in noninterest income during the three and nine months ended September 30, 2017 and 2016: 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
Amount
 
Amount
 
Percentage
Change
 
Amount
 
Amount
 
Percentage
Change
 
2017
 
2016
 
2017 vs. 2016
 
2017
 
2016
 
2017 vs. 2016
 
(Dollars in thousands)
Service fees on deposits and other banking services
$
346

 
$
279

 
24.0
 %
 
$
985

 
$
801

 
23.0
 %
Net loss on sale of other assets
(16
)
 

 
 %
 
(14
)
 

 
100.0
 %
Net gain on sale of small business administration loans

 

 
 %
 

 
40

 
(100.0
)%
Other noninterest income
634

 
775

 
(18.2
)%
 
2,393

 
1,830

 
30.8
 %
Total noninterest income
$
964

 
$
1,054

 
(8.5
)%
 
$
3,364

 
$
2,671

 
25.9
 %
Three Months Ended September 30, 2017 and 2016
Noninterest income decreased by $90 thousand, or 8.5%, for the three months ended September 30, 2017 as compared to the three months ended September 30, 2016, primarily as a result of $340 thousand in recoveries during the third quarter of 2016 that exceeded the amount previously charged off against the ALLL, which was partially offset by an increase in loan servicing and referral fees during the third quarter of 2017.
Nine Months Ended September 30, 2017 and 2016
Noninterest income increased $693 thousand, or 25.9%, for the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016, primarily as a result of:
The recovery of $373 thousand in recoveries during the second quarter of 2017 that exceeded the amount previously charged off against the ALLL; and
An increase in loan servicing and referral fees during the nine months ended September 30, 2017 as compared to the same period in 2016; partially offset by
A decrease of $40 thousand in net gain on sale of small business administration loans for the nine months ended September 30, 2017 as compared to the same period in 2016.
Noninterest Expense
The following table sets forth the principal components and the amounts of, and the percentage changes in, noninterest expense during the three and nine months ended September 30, 2017 and 2016.

40


 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017 vs. 2016
 
2017
 
2016
 
2017 vs. 2016
 
Amount
 
Amount
 
Percent Change
 
Amount
 
Amount
 
Percent Change
 
(Dollars in thousands)
Salaries and employee benefits
$
5,796

 
$
5,727

 
1.2
 %
 
$
17,171

 
$
16,920

 
1.5
 %
Occupancy
659

 
794

 
(17.0
)%
 
1,958

 
2,332

 
(16.0
)%
Equipment and depreciation
430

 
502

 
(14.3
)%
 
1,248

 
1,374

 
(9.2
)%
Data processing
377

 
340

 
10.9
 %
 
1,063

 
942

 
12.8
 %
FDIC expense
294

 
229

 
28.4
 %
 
859

 
675

 
27.3
 %
Other real estate owned expense, net

 

 
 %
 

 
(70
)
 
(100.0
)%
Professional fees
958

 
1,110

 
(13.7
)%
 
3,100

 
2,435

 
27.3
 %
Business development
139

 
199

 
(30.2
)%
 
496

 
543

 
(8.7
)%
Loan related expense
(5
)
 
152

 
(103.3
)%
 
194

 
264

 
(26.5
)%
Insurance
62

 
69

 
(10.1
)%
 
186

 
221

 
(15.8
)%
Other operating expenses (1)
466

 
565

 
(17.5
)%
 
1,374

 
1,499

 
(8.3
)%
Total noninterest expense
$
9,176

 
$
9,687

 
(5.3
)%
 
$
27,649

 
$
27,135

 
1.9
 %
 
(1)
Other operating expenses primarily consist of telephone, advertising, director fees, regulatory expenses, and correspondent bank fees.
Three Months Ended September 30, 2017 and 2016
Noninterest expense decreased $511 thousand, or 5.3%, for the three months ended September 30, 2017 as compared to the three months ended September 30, 2016, primarily as a result of:
A decrease of $152 thousand in our professional fees primarily related to lower accounting fees in 2017;
A decrease of $157 thousand in loan-related expenses as a result of the reversal of our mortgage repurchase reserve; and
A decrease of $135 thousand in occupancy expenses as a result of moving costs incurred in the prior year period associated with the transition of a few of our locations from full-service branches to loan production offices, which expenses were not incurred during the three months ended September 30, 2017.
Nine Months Ended September 30, 2017 and 2016
Noninterest expense increased $514 thousand, or 1.9%, for the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016, primarily as a result of an increase of $665 thousand in our professional fees attributable to an increase in accounting and legal fees during the nine months ended September 30, 2017.

41


Provision for Income Tax    
For the three and nine months ended September 30, 2017, we had income tax expense of $37 thousand and $150 thousand, respectively. The income tax expense for the three and nine months ended September 30, 2017 represents the payment to the State of California for the cost of doing business within the state and an estimated alternative minimum tax payment. No additional income tax expense was recorded as a result of our net operating loss carryforward. Accounting rules specify that management must evaluate the deferred tax asset on a recurring basis to determine whether enough positive evidence exists to determine whether it is more-likely-than-not that the deferred tax asset will be available to offset or reduce future taxes. Negative evidence included the net loss incurred in 2016, a cumulative three-year loss position, and our accumulated deficit. Positive evidence included our net income for the three and nine months ended September 30, 2017, a decrease in our nonperforming assets from December 31, 2016, the forecast of our taxable income, the time period in which we have to utilize our deferred tax asset and the current economic conditions. The tax code allows net operating losses to be carried forward for 20 years from the date of the loss, and while management believes that the Company will be able to realize the deferred tax asset within that period, we are unable to assert the timing as to when that realization will occur. As a result of this conclusion and due to the hierarchy of evidence that the accounting rules specify, management determined that the valuation allowance of $21.7 million that was previously established on the balance of our deferred tax asset was still required at September 30, 2017.
For the three and nine months ended September 30, 2016, we had income tax expense of $20.4 million and $17.0 million, respectively, as a result of the establishment of a full valuation allowance during the three months ended September 30, 2016 on the balance of our deferred tax asset, which includes current and historical losses that may be used to offset taxes on future profits. Negative evidence included the significant losses incurred during the second and third quarters of 2016, an increase in our nonperforming assets from December 31, 2015 to September 30, 2016, a cumulative three-year loss position, and our accumulated deficit. Positive evidence included our forecast of our taxable income, the time period in which we have to utilize our deferred tax asset and the current economic conditions. While management believed that the Company would be able to realize the deferred tax asset within the period that our net operating losses may be carried forward, we were unable to assert the timing as to when that realization would occur. As a result of this conclusion and due to the hierarchy of evidence that the accounting rules specify, a valuation allowance was recorded as of September 30, 2016 to offset the deferred tax asset.

Financial Condition
Assets
Our total assets increased by $64 million at September 30, 2017 compared to December 31, 2016. The following table sets forth the composition of our interest earning assets at:
 
September 30, 2017
 
December 31, 2016
 
(Dollars in thousands)
Interest-bearing deposits with financial institutions (1)
$
92,687

 
$
122,056

Interest-bearing time deposits with financial institutions
3,419

 
3,669

Federal Reserve Bank of San Francisco and Federal Home Loan Bank Stock, at cost
7,790

 
8,170

Securities available for sale, at fair value
41,935

 
43,480

Loans (net of allowances of $15,048 and $16,801, respectively)
1,027,896

 
931,525

 
(1)
Includes interest-earning balances maintained at the FRBSF.
Investment Portfolio
Securities Available for Sale. Securities that we intend to hold for an indefinite period of time, but which may be sold in response to changes in liquidity needs, in interest rates, or in prepayment risks or other similar factors, are classified as “securities available for sale”. Such securities are recorded on our balance sheet at their respective fair values and increases or decreases in those values are recorded as unrealized gains or losses, respectively, and are reported as other comprehensive income (loss) on our accompanying consolidated statements of financial condition, rather than included in or deducted from our earnings.
The following is a summary of the major components of securities available for sale and a comparison of the amortized cost, estimated fair values and the gross unrealized gains and losses attributable to those securities, as of September 30, 2017 and December 31, 2016:

42


(Dollars in thousands)
Amortized Cost
 
Gross
Unrealized Gain
 
Gross
Unrealized Loss
 
Estimated
Fair Value
Securities available for sale at September 30, 2017:
 
 
 
 
 
 
 
U.S. Treasury securities
$
2,995

 
$

 
$
(8
)
 
$
2,987

Residential mortgage backed securities issued by U.S. Agencies
32,469

 
7

 
(558
)
 
31,918

Residential collateralized mortgage obligations issued by non agencies
399

 
5

 

 
404

Asset backed security
2,000

 

 
(310
)
 
1,690

Mutual funds
5,000

 
16

 
(80
)
 
4,936

Total securities available for sale
$
42,863

 
$
28

 
$
(956
)
 
$
41,935

Securities available for sale at December 31, 2016:
 
 
 
 
 
 
 
Residential mortgage backed securities issued by U.S. Agencies
$
37,813

 
$
6

 
$
(1,144
)
 
$
36,675

Residential collateralized mortgage obligations issued by non agencies
484

 

 
(16
)
 
468

Asset backed security
2,025

 

 
(592
)
 
1,433

Mutual funds
5,000

 
11

 
(107
)
 
4,904

Total securities available for sale
$
45,322

 
$
17

 
$
(1,859
)
 
$
43,480

The amortized cost of securities available for sale at September 30, 2017 is shown in the table below by contractual maturities taking into consideration historical prepayments based on the prior twelve months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, primarily because prepayment rates are affected by changes in conditions in the interest rate market and, therefore, future prepayment rates may differ from historical prepayment rates.
 
September 30, 2017 Maturing in
 
One year or less
 
Over one year through five years
 
Over five years through ten years
 
Over ten years
 
Total
(Dollars in thousands)
Amortized Cost
 
Weighted
Average
Yield
 
Amortized Cost
 
Weighted
Average
Yield
 
Amortized Cost
 
Weighted
Average
Yield
 
Amortized Cost
 
Weighted
Average
Yield
 
Amortized Cost
 
Weighted
Average
Yield
Securities available for sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$

 
%
 
$
2,995

 
1.30
%
 
$

 
%
 
$

 
%
 
$
2,995

 
1.30
%
Residential mortgage-backed securities issued by U.S. Agencies
6,380

 
1.46
%
 
16,813

 
1.49
%
 
8,759

 
1.59
%
 
517

 
2.12
%
 
32,469

 
1.52
%
Non-agency collateralized mortgage obligations
399

 
3.90
%
 

 
%
 

 

 

 

 
399

 
3.90
%
Asset backed securities

 

 

 

 

 

 
2,000

 
3.88
%
 
2,000

 
3.88
%
Mutual funds

 

 
5,000

 
2.03
%
 

 

 

 

 
5,000

 
2.03
%
Total Securities Available for sale
$
6,779

 
1.60
%
 
$
24,808

 
1.57
%
 
$
8,759

 
1.59
%
 
$
2,517

 
3.52
%
 
$
42,863

 
1.70
%

43



Loans
The following table sets forth the composition, by loan category, of our loan portfolio at September 30, 2017 and December 31, 2016:
 
September 30, 2017
 
December 31, 2016
 
Amount
 
Percent
 
Amount
 
Percent
 
(Dollars in thousands)
Commercial loans
$
364,242

 
35.0
%
 
$
333,376

 
35.2
%
Commercial real estate loans – owner occupied
211,514

 
20.3
%
 
214,420

 
22.7
%
Commercial real estate loans – all other
235,319

 
22.6
%
 
173,223

 
18.3
%
Residential mortgage loans – multi-family
123,698

 
11.9
%
 
130,930

 
13.8
%
Residential mortgage loans – single family
27,983

 
2.7
%
 
34,527

 
3.6
%
Construction and land development loans
28,461

 
2.7
%
 
18,485

 
2.0
%
Consumer loans
48,801

 
4.7
%
 
41,563

 
4.4
%
Total loans
1,040,018

 
100.0
%
 
946,524

 
100.0
%
Deferred loan origination costs, net
2,926

 
 
 
1,802

 
 
Allowance for loan and lease losses
(15,048
)
 
 
 
(16,801
)
 
 
Loans, net
$
1,027,896

 
 
 
$
931,525

 
 
Commercial loans are loans to businesses to finance capital purchases or improvements, or to provide cash flow for operations. Commercial real estate and residential mortgage loans are loans secured by trust deeds on real properties, including commercial properties and single family and multi-family residences. Construction and land development loans are loans secured by commercial construction or non-arable bare land. Consumer loans include installment loans to consumers.
The following table sets forth the maturity distribution of our loan portfolio (excluding single and multi-family residential mortgage loans and consumer loans) at September 30, 2017:
 
September 30, 2017
 
One Year
or Less
 
Over One
Year
Through
Five Years
 
Over Five
Years
 
Total
 
(Dollars in thousands)
Real estate loans(1)
 
 
 
 
 
 
 
Floating rate
$
26,003

 
$
48,510

 
$
119,225

 
$
193,738

Fixed rate
7,233

 
64,804

 
209,519

 
281,556

Commercial loans
 
 
 
 
 
 
 
Floating rate
117,269

 
137,626

 
34,834

 
289,729

Fixed rate
22,849

 
34,267

 
17,397

 
74,513

Total
$
173,354

 
$
285,207

 
$
380,975

 
$
839,536

 
(1)
Does not include mortgage loans on single or multi-family residences or consumer loans, which totaled $151.7 million and $48.8 million, respectively, at September 30, 2017.
Nonperforming Assets and Allowance for Loan and Lease Losses
Nonperforming Assets. Nonperforming loans consist of (i) loans on nonaccrual status which are loans on which the accrual of interest has been discontinued and include restructured loans when there has not been a history of past performance on debt service in accordance with the contractual terms of the restructured loans, and (ii) loans 90 days or more past due and still accruing interest. Nonperforming assets are comprised of non-performing loans and OREO, which consists of real properties which we have acquired by or in lieu of foreclosure and which we intend to offer for sale.
Loans are placed on nonaccrual status when, in our opinion, the full timely collection of principal or interest is in doubt. Generally, the accrual of interest is discontinued when principal or interest payments become more than 90 days past due, unless we believe the loan is adequately collateralized and the loan is in the process of collection. However, in certain instances, we may place a particular loan on nonaccrual status earlier, depending upon the individual circumstances involved in that loan’s delinquency. When a loan is placed on nonaccrual status, previously accrued but unpaid interest is reversed against current income. Subsequent collections of unpaid amounts on such a loan are applied to reduce principal when received, except when the ultimate collectability

44


of principal is probable, in which case such payments are applied to interest and are credited to income. Nonaccrual loans may be restored to accrual status if and when principal and interest become current and full repayment is expected. Interest income is recognized on the accrual basis for impaired loans which, based on our non-accrual policy, do not require nonaccrual treatment.
The following table sets forth information regarding our nonperforming assets, as well as information regarding restructured loans, at September 30, 2017 and December 31, 2016:
 
At September 30, 2017
 
At December 31, 2016
 
(Dollars in thousands)
Nonaccrual loans:
 
 
 
Commercial loans
$
7,356

 
$
20,330

Commercial real estate
2,749

 
4,346

Residential real estate
174

 
221

Total nonaccrual loans
$
10,279

 
$
24,897

Loans past due 90 days and still accruing interest:
 
 
 
Total loans past due 90 days and still accruing interest
$

 
$

Other nonperforming assets:
 
 
 
Other foreclosed assets
95

 

Total nonperforming assets
$
10,374

 
$
24,897

Restructured loans:
 
 
 
Accruing loans
$
489

 
$

Nonaccruing loans (included in nonaccrual loans above)
1,101

 
8,931

Total restructured loans
$
1,590

 
$
8,931

As the above table indicates, total nonperforming assets decreased by approximately $14.5 million, or 58.3%, to $10.4 million as of September 30, 2017 from $24.9 million as of December 31, 2016. The decrease in our non-performing loans resulted primarily from $20.5 million in payoffs or paydowns on our nonaccrual loans, $3.3 million charged-off, $825 thousand returning to accrual status and $217 thousand transferred to other assets during the nine months ended September 30, 2017, partially offset by $10.2 million moving to nonaccrual status during the same period. The increase in our other foreclosed assets balance from December 31, 2016 related to the foreclosure of three automobiles during the nine months ended September 30, 2017, which have been listed for sale as of September 30, 2017.
Information Regarding Impaired Loans. At September 30, 2017, loans deemed impaired totaled $10.8 million as compared to $24.9 million at December 31, 2016. We had an average investment in impaired loans of $16.8 million and $21.1 million, respectively, for the three and nine months ended September 30, 2017 as compared to $26.8 million and $28.7 million, respectively, for the three and nine months ended September 30, 2016. The interest that would have been earned during the nine months ended September 30, 2017 had the nonaccruing impaired loans remained current in accordance with their original terms was approximately $563 thousand.
The following table sets forth the amount of impaired loans to which a portion of the ALLL has been specifically allocated, and the aggregate amount so allocated, in accordance with Accounting Standards Codification 310-10, and the amount of the ALLL and the amount of impaired loans for which no such allocations were made, in each case at September 30, 2017 and December 31, 2016:
 
September 30, 2017
 
December 31, 2016
 
Loans
 
Reserves for
Loan Losses
 
% of
Reserves to
Loans
 
Loans
 
Reserves for
Loan Losses
 
% of
Reserves to
Loans
 
(Dollars in thousands)
Impaired loans with specific reserves
$
4,980

 
$
451

 
9.1
%
 
$
3,309

 
$
2,042

 
61.7
%
Impaired loans without specific reserves
5,788

 

 

 
21,588

 

 

Total impaired loans
$
10,768

 
$
451

 
4.2
%
 
$
24,897

 
$
2,042

 
8.2
%
The $14.1 million decrease in impaired loans to $10.8 million at September 30, 2017 from $24.9 million at December 31, 2016 was primarily attributable to $20.3 million in principal payments, $711 thousand transferred to performing loans, $217 thousand transferred to other assets and $3.3 million charged-off during the nine months ended September 30, 2017 partially offset by additions of $10.7 million to impaired loans during the same period. Based on an internal analysis, using the current estimated fair values of the collateral or the discounted present values of the future estimated cash flows of the impaired loans, we concluded

45


that, at September 30, 2017, $451 thousand of specific reserves were required on four impaired loans and that all remaining impaired loans were well secured and adequately collateralized with no specific reserves required.
Allowance for Loan and Lease Losses. The ALLL totaled $15.0 million, representing 1.45% of loans outstanding, at September 30, 2017, as compared to $16.8 million, or 1.78% of loans outstanding, at December 31, 2016.
The adequacy of the ALLL is determined through periodic evaluations of the loan portfolio and other factors that can reasonably be expected to affect the ability of borrowers to meet their loan obligations. Those factors are inherently subjective as the process for determining the adequacy of the ALLL involves some significant estimates and assumptions about such matters such as (i) economic conditions and trends and the amounts and timing of expected future cash flows of borrowers which can affect their ability to meet their loan obligations to us, (ii) the fair value of the collateral securing non-performing loans, (iii) estimates of losses that we may incur on non-performing loans, which are determined on the basis of historical loss experience and industry loss factors and bank regulatory guidelines, which are subject to change, and (iv) various qualitative factors. Since those factors are subject to changes in economic and other conditions and changes in regulatory guidelines or other circumstances over which we have no control, the amount of the ALLL may prove to be insufficient to cover all of the loan losses we might incur in the future. In such an event, it may become necessary for us to increase the ALLL from time to time to maintain its adequacy. Such increases are effectuated by means of a charge to income, referred to as the “provision for loan and lease losses”, in our statements of our operations. See “—Results of OperationsProvision for Loan and Lease Losses, above in this Item 2.
The amount of the ALLL is first determined by assigning reserve ratios for all loans. All non-accrual loans and other loans classified as “Special Mention,” “Substandard” or “Doubtful” (“classified loans” or “classification categories”) and not fully collateralized are then assigned specific reserves within the ALLL, with greater reserve allocations made to loans deemed to be of a higher risk. These ratios are determined based on prior loss history and industry guidelines and loss factors, by type of loan, adjusted for current economic factors and current economic trends. Refer to Note 5, Loans and Allowance for Loan and Lease Losses, in Item 1 for definitions related to our internal asset quality indicators stated above.
On a quarterly basis, we utilize a classification based loan loss migration model as well as review individual loans in determining the adequacy of the ALLL. Our loss migration analysis tracks a certain number of quarters of loan loss history and industry loss factors to determine historical losses by classification category for each loan type, except certain consumer loans (automobile, mortgage and credit cards), which are analyzed as homogeneous loan pools. These calculated loss factors are then applied to outstanding loan balances. We analyze impaired loans individually.
In determining whether and the extent to which we will make adjustments to our loan loss migration model for purposes of determining the ALLL, we also consider a number of qualitative factors that can affect the performance and the collectability of the loans in our loan portfolio. Such qualitative factors include:
The effects of changes that we may make in our loan policies or underwriting standards on the quality of the loans and the risks in our loan portfolios;
Trends and changes in local, regional and national economic conditions, as well as changes in industry specific conditions, and any other reasonably foreseeable events that could affect the performance or the collectability of the loans in our loan portfolios;
Material changes that may occur in the mix or in the volume of the loans in our loan portfolios that could alter, whether positively or negatively, the risk profile of those portfolios;
Changes in management or loan personnel or other circumstances that could, either positively or negatively, impact the application of our loan underwriting standards, the monitoring of nonperforming loans or our loan collection efforts; and
External factors that, in addition to economic conditions, can affect the ability of borrowers to meet their loan obligations, such as fires, earthquakes and terrorist attacks.
Determining the effects that these qualitative factors may have on the performance of each category of loans in our loan portfolio requires numerous judgments, assumptions and estimates about conditions, trends and events which may subsequently prove to have been incorrect due to circumstances outside of our control. Moreover, the effects of qualitative factors such as these on the performance of our loan portfolios are often difficult to quantify. As a result, we may sustain loan losses in any particular period that are sizable in relation to the ALLL or that may even exceed the ALLL.

46


Set forth below is information regarding loan balances and the related ALLL, by portfolio type, for the nine months ended September 30, 2017 and 2016.
(Dollars in thousands)
Commercial
 
Real  Estate
 
Construction and land
Development
 
Consumer 
and Single
Family
Mortgages
 
Unallocated
 
Total
ALLL for the nine months ended September 30, 2017:
 
 
 
 
 
 
 
 
 
 
 
Balance at beginning of year
$
11,276

 
$
4,226

 
$
343

 
$
642

 
$
314

 
$
16,801

Charge offs
(2,694
)
 
(432
)
 

 
(161
)
 

 
(3,287
)
Recoveries
1,334

 

 
27

 
173

 

 
1,534

Provision
(751
)
 
248

 
(24
)
 
338

 
189

 

Balance at end of year
$
9,165

 
$
4,042

 
$
346

 
$
992

 
$
503

 
$
15,048

Allowance for loan and lease losses as a percentage of average total loans
 
 
 
 
 
 
 
 
 
 
1.53
%
Allowance for loan and lease losses as a percentage of total outstanding loans
 
 
 
 
 
 
 
 
 
 
1.45
%
Ratio of net charge-offs to average loans outstanding (annualized)
 
 
 
 
 
 
 
 
 
 
0.24
%
ALLL for the nine months ended September 30, 2016:
 
 
 
 
 
 
 
 
 
 
 
Balance at beginning of year
$
6,639

 
$
5,109

 
$
282

 
$
686

 
$

 
$
12,716

Charge offs
(16,356
)
 
(1,119
)
 

 
540

 

 
(16,935
)
Recoveries
979

 
1

 

 
11

 

 
991

Provision
21,019

 
(574
)
 
26

 
(601
)
 

 
19,870

Balance at end of year
$
12,281

 
$
3,417

 
$
308

 
$
636

 
$

 
$
16,642

Allowance for loan and lease losses as a percentage of average total loans
 
 
 
 
 
 
 
 
 
 
1.96
%
Allowance for loan and lease losses as a percentage of total outstanding loans
 
 
 
 
 
 
 
 
 
 
1.91
%
Ratio of net charge-offs to average loans outstanding (annualized)
 
 
 
 
 
 
 
 
 
 
2.51
%
The ALLL decreased $1.6 million from September 30, 2016 to September 30, 2017 primarily as a result of a decrease in our classified loan portfolio during 2017, which was partially offset by charge offs exceeding recoveries and new loan growth during that same period. The reserve for loan losses may include an unallocated amount based upon our judgment as to possible credit losses inherent in the loan portfolio that may not have been captured by historical loss experience, qualitative factors, or specific evaluations of impaired loans. Unallocated reserves may be adjusted for factors including, but not limited to, unexpected or unusual events, volatile market and economic conditions, effects of changes or seasoning in methodologies, regulatory guidance and recommendations, or other factors that may impact borrower operating conditions and loss expectations. Management’s judgment as to unallocated reserves is determined in the context of, but separate from, the historical loss trends and qualitative factors described above. The unallocated reserve for loan losses of $503 thousand at September 30, 2017 has increased $189 thousand from the balance at December 31, 2016, primarily due to some uncertainties related to our classified loans as of September 30, 2017, partially offset by charge-offs during the three months ended September 30, 2017.  Management believes that the amount of unallocated reserve for loan losses is appropriate and will continue to evaluate it on an ongoing basis.
We classify our loan portfolios using asset quality ratings. The credit quality table in Note 5, Loans and Allowance for Loan and Lease Losses above in Item 1, provides a summary of loans by portfolio type and asset quality ratings as of September 30, 2017 and December 31, 2016. Loans totaled approximately $1.0 billion at September 30, 2017, an increase of $93.5 million from $946.5 million at December 31, 2016. The disaggregation of the loan portfolio by risk rating in the credit quality table located in Note 5 reflects the following changes that occurred between December 31, 2016 and September 30, 2017:
Loans rated “Pass” totaled $1.0 billion, an increase of $126.1 million from $879.8 million at December 31, 2016. The increase was primarily attributable to new loan growth and upgrades of $2.9 million and $4.8 million from “Special Mention” and “Substandard”, respectively, partially offset by downgrades to “Special Mention” and “Substandard" of $7.6 million and $6.2 million, respectively, and paydowns of principal payments.

47


Loans rated “Special Mention” totaled $17.2 million, an increase of $2.4 million from $14.7 million at December 31, 2016. The increase was primarily the result of $7.6 million downgraded from “Pass”, $667 thousand upgraded from “Substandard”, and $497 thousand of existing line draws, partially offset by $2.9 million upgraded to “Pass”, $795 thousand downgraded to “Substandard” and payoffs and principal payments.
Loans rated “Substandard” totaled $16.9 million, a decrease of $31.8 million from $48.7 million at December 31, 2016. This decrease was primarily the result of $32.4 million in principal payments, $4.8 million of loans upgraded to “Pass”, $826 thousand upgraded to “Special Mention” and $3.1 million of loans charged off, partially offset by $6.2 million downgraded from “Pass”, $497 thousand downgraded from “Special Mention” and $2.7 million upgraded from “Doubtful”.
Loans rated “Doubtful” totaled $0.0 million, a decrease of $3.3 million from $3.3 million at December 31, 2016. This decrease was the result of two commercial loans of $3.2 million upgraded to “Substandard” and the payoff of $151 thousand related to one commercial loan.
Our loss migration analysis currently utilizes a series of twelve staggered 16-quarter migration periods, which was increased during the second quarter of 2015 from four staggered 16-quarter migration periods in order to broaden the loss experience incorporated into the analysis. As a result, for purposes of determining applicable loss factors at September 30, 2017, our migration analysis covered the period from March 31, 2012 to September 30, 2016. We believe this was consistent with and reasonably reflects current economic conditions, portfolio trends and the risks that were inherent in our loan portfolio at September 30, 2017.
The table below sets forth loan delinquencies, by quarter, for the five preceding quarters ended September 30, 2017.
 
September 30, 2017
 
June 30, 2017
 
March 31, 2017
 
December 31, 2016
 
September 30, 2016
Loans Delinquent:
(Dollars in thousands)
90 days or more:
 
 
 
 
 
 
 
 
 
Commercial loans
$
2,212

 
$
12,261

 
$
15,406

 
$
13,946

 
$
8,663

Commercial real estate

 

 
432

 
1,003

 
1,011

Construction and land development loans

 

 

 

 

 
2,212

 
12,261

 
15,838

 
14,949

 
9,674

30-89 days:
 
 
 
 
 
 
 
 
 
Commercial loans
1,561

 
4,129

 
1,239

 
7,055

 
6,287

Commercial real estate
955

 
968

 
995

 
4,142

 
1,034

Residential mortgages

 

 

 

 
62

Consumer loans

 

 
261

 
38

 

 
2,516

 
5,097

 
2,495

 
11,235

 
7,383

Total Past Due(1):
$
4,728

 
$
17,358

 
$
18,333

 
$
26,184

 
$
17,057

 
(1)
Past due balances include nonaccrual loans.
As the above table indicates, total past due loans decreased by $21.5 million, to $4.7 million at September 30, 2017 from $26.2 million at December 31, 2016. Loans past due 90 days or more decreased by $12.7 million, to $2.2 million at September 30, 2017, from $14.9 million at December 31, 2016 primarily resulting from $13.4 million of payoffs and one loan relationship of $1.5 million brought current, partially offset by $1.1 million migrating from "30-89 days past due" to "past due 90 days or more" and additions of $1.1 million.
Loans 30-89 days past due decreased by $8.7 million to $2.5 million at September 30, 2017 from $11.2 million at December 31, 2016 primarily attributable to $1.1 million moving to “past due 90 days or more”, $4.6 million of payoffs, $2.1 million brought current, and $2.0 million charged off, partially offset by $1.3 million of additions.
Deposits
Average Balances of and Average Interest Rates Paid on Deposits
Set forth below are the average amounts of, and the average rates paid on, deposits for the nine months ended September 30, 2017 and year ended December 31, 2016:

48


 
Nine Months Ended September 30, 2017
 
Year Ended December 31, 2016
 
Average
Balance
 
Average
Rate
 
Average
Balance
 
Average
Rate
 
(Dollars in thousands)
Noninterest bearing demand deposits
$
321,808

 

 
$
299,447

 

Interest-bearing checking accounts
88,962

 
0.38
%
 
60,024

 
0.27
%
Money market and savings deposits
340,464

 
0.82
%
 
327,401

 
0.63
%
Time deposits(1)
279,630

 
1.18
%
 
263,569

 
0.99
%
Total deposits
$
1,030,864

 
0.62
%
 
$
950,441

 
0.51
%
 
 
(1)
Comprised of time certificates of deposit in denominations of less than and more than $100,000.
Deposit Totals
Deposits totaled $1.1 billion at September 30, 2017 as compared to $1.0 billion at December 31, 2016. The following table provides information regarding the mix of our deposits at September 30, 2017 and December 31, 2016:
 
At September 30, 2017
 
At December 31, 2016
 
Amounts
 
% of Total Deposits
 
Amounts
 
% of Total Deposits
 
(Dollars in thousands)
Deposits
 
 
 
 
 
 
 
Noninterest bearing demand deposits
$
320,248

 
30.5
%
 
$
332,573

 
33.2
%
Savings and other interest-bearing transaction deposits
406,469

 
38.5
%
 
410,819

 
41.0
%
Time deposits(1)
327,803

 
31.1
%
 
257,908

 
25.8
%
Total deposits
$
1,054,520

 
100.0
%
 
$
1,001,300

 
100.0
%
 
 
(1)
Comprised of time certificates of deposit in denominations of less than and more than $100,000.
Certificates of deposit in denominations of $100,000 or more, on which we pay higher rates of interest than on other deposits, aggregated $296.9 million, or 28.2%, of total deposits at September 30, 2017, as compared to $227.2 million, or 22.7%, of total deposits at December 31, 2016.
Set forth below is a maturity schedule of domestic time certificates of deposit outstanding at September 30, 2017 and December 31, 2016:
 
September 30, 2017
 
December 31, 2016
Maturities
Certificates of
Deposit Under
$ 100,000
 
Certificates of
Deposit $100,000
or more
 
Certificates of
Deposit Under
$100,000
 
Certificates of
Deposit $100,000
or more
 
(Dollars in thousands)
Three months or less
$
6,094

 
$
45,856

 
$
9,269

 
$
72,671

Over three and through six months
9,419

 
77,952

 
4,794

 
35,800

Over six and through twelve months
11,105

 
97,817

 
11,077

 
75,932

Over twelve months
4,244

 
75,316

 
5,577

 
42,788

Total
$
30,862

 
$
296,941

 
$
30,717

 
$
227,191



Liquidity
We actively manage our liquidity needs to ensure that sufficient funds are available to meet our needs for cash, including to fund new loans and deposit withdrawals by our customers. We project the future sources and uses of funds and maintain liquid funds for unanticipated events. Our primary sources of cash include cash we have on deposit at other financial institutions, payments from borrowers on their loans, proceeds from sales or maturities of securities held for sale, sales of residential mortgage loans, increases in deposits and increases in borrowings principally from the FHLB. The primary uses of cash include funding new loans and making advances on existing lines of credit, purchasing investments, including securities available for sale, funding new residential mortgage loans, funding deposit withdrawals and paying operating expenses. We maintain funds in overnight federal

49


funds and other short-term investments to provide for short-term liquidity needs. We also have obtained credit lines from the FHLB and other financial institutions to meet any additional liquidity requirements we might have. See "—Contractual Obligations—Borrowings" below for additional information related to our borrowings from the FHLB.
Our liquid assets, which included cash and due from banks, federal funds sold, interest earning deposits that we maintain with financial institutions and unpledged securities available for sale (excluding FRBSF and FHLB stock) totaled $126.5 million, which represented 10% of total assets, at September 30, 2017. We believe that our cash and cash equivalent resources, together with available borrowings under our credit facilities, will be sufficient to meet normal operating requirements for at least the next twelve months, including to enable us to meet any increase in deposit withdrawals that might occur in the foreseeable future.
Cash Flow Provided by Operating Activities. During the nine months ended September 30, 2017, operating activities provided net cash of $7.8 million, primarily attributable to our net income of $8.0 million, partially offset by an increase in our other assets and accrued interest receivable. During the nine months ended September 30, 2016, operating activities provided net cash of $2.3 million, attributable to non-cash adjustments to our net loss, which primarily related to the provision for loan and lease losses and the valuation allowance established on our deferred tax asset during the nine months ended September 30, 2016.
Cash Flow Used in Investing Activities. During the nine months ended September 30, 2017, investing activities used net cash of $93.0 million, primarily attributable to $95.7 million used to fund an increase in loans and $3.0 million for the purchase of securities available for sale and stock, partially offset by $5.7 million of cash from maturities of and principal payments on securities available for sale and other stock. During the nine months ended September 30, 2016, investing activities used net cash of $18.5 million, primarily attributable to $25.7 million used to fund an increase in loans, partially offset by $6.0 million of cash from maturities and principal payments on securities available for sale and proceeds of $757 thousand from the sale of OREO.
Cash Flow Provided by Financing Activities. During the nine months ended September 30, 2017, financing activities provided net cash of $54.2 million, consisting of a $53.2 million increase in our deposits, which was primarily the result of new client acquisition, $30.0 million in proceeds from FHLB borrowings and $996 thousand from the exercise of stock options, partially offset by a $30.0 million decrease in borrowings. During the nine months ended September 30, 2016, financing activities provided net cash of $46.8 million, consisting of a $56.3 million increase in our deposits, which was primarily the result of new client acquisition, partially offset by a $10.0 million decrease in borrowings.
Ratio of Loans to Deposits. The relationship between gross loans and total deposits can provide a useful measure of a bank’s liquidity. Since repayment of loans tends to be less predictable than the maturity of investments and other liquid resources, the higher the loan-to-deposit ratio the less liquid are our assets. On the other hand, since we realize greater yields on loans than we do on investments, a lower loan-to-deposit ratio can adversely affect interest income and earnings. As a result, our goal is to achieve a loan-to-deposit ratio that appropriately balances the requirements of liquidity and the need to generate a fair return on our assets. At September 30, 2017 and December 31, 2016, the loan-to-deposit ratio was 99% and 95%, respectively.
Capital Resources
Regulatory Capital Requirements Applicable to Banking Institutions
Under federal banking regulations that apply to all United States based bank holding companies and federally insured banks, the Company (on a consolidated basis) and the Bank (on a stand-alone basis) must meet specific capital adequacy requirements that, for the most part, involve quantitative measures, primarily in terms of the ratios of their capital to their assets, liabilities, and certain off-balance sheet items, calculated under regulatory accounting practices. Under those regulations, each bank holding company must meet a minimum capital ratio and each federally insured bank is determined by its primary federal bank regulatory agency to come within one of the following capital adequacy categories on the basis of its capital ratios:
well-capitalized
adequately capitalized
undercapitalized
significantly undercapitalized; or
critically undercapitalized
Certain qualitative assessments also are made by a banking institution’s primary federal regulatory agency that could lead the agency to determine that the banking institution should be assigned to a lower capital category than the one indicated by the quantitative measures used to assess the institution’s capital adequacy. At each successive lower capital category, a banking institution is subject to greater operating restrictions and increased regulatory supervision by its federal bank regulatory agency.
The following table sets forth the capital and capital ratios of the Company (on a consolidated basis) and the Bank (on a stand-alone basis) at September 30, 2017, as compared to the respective regulatory requirements applicable to them.
 

50


 
 
 
 
 
Applicable Federal Regulatory Requirement
 
 
 
For Capital
Adequacy Purposes
 
To be Categorized As
Well-Capitalized
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
 
(Dollars in thousands)
Total Capital to Risk Weighted Assets:
 
 
 
 
 
 
 
 
 
 
 
Company
$
142,421

 
12.2
%
 
$
100,550

 
At least 8.625
 
N/A

 
N/A
Bank
134,355

 
11.6
%
 
100,370

 
At least 8.625
 
$
116,371

 
At least 10.0
Common Equity Tier 1 Capital to Risk Weighted Assets:
 
 
 
 
 
 
 
 
 
 
 
Company
$
110,839

 
9.5
%
 
$
59,747

 
At least 5.125
 
N/A

 
N/A
Bank
119,799

 
10.3
%
 
59,640

 
At least 5.125
 
$
75,641

 
At least 6.5
Tier 1 Capital to Risk Weighted Assets:
 
 
 
 
 
 
 
 
 
 
 
Company
$
127,839

 
11.0
%
 
$
77,234

 
At least 6.625
 
N/A

 
N/A
Bank
119,799

 
10.3
%
 
77,095

 
At least 6.625
 
$
93,096

 
At least 8.0
Tier 1 Capital to Average Assets:
 
 
 
 
 
 
 
 
 
 
 
Company
$
127,839

 
10.8
%
 
$
47,387

 
At least 4.0
 
N/A

 
N/A
Bank
119,799

 
10.2
%
 
47,174

 
At least 4.0
 
$
58,967

 
At least 5.0
As the above table indicates, at September 30, 2017, the Bank (on a stand-alone basis) qualified as a “well—capitalized” institution, and the capital ratios of the Company (on a consolidated basis) exceeded the capital ratios mandated for bank holding companies, under federally mandated capital standards and federally established prompt corrective action regulations. Since September 30, 2017, there have been no events or circumstances known to us which have changed or which are expected to result in a change in the Company’s or the Bank’s classifications as well-capitalized institutions.
In early July 2013, the Federal Reserve Board and the FDIC issued final rules implementing the Basel III regulatory capital framework and related Dodd-Frank Wall Street Reform and Consumer Protection Act changes.  The rules revise minimum capital requirements and adjust prompt corrective action thresholds.  The final rules revise the regulatory capital elements, add a new common equity Tier 1 capital ratio, increase the minimum Tier 1 capital ratio requirement, and implement a new capital conservation buffer.  The rules also permit certain banking organizations to retain, through a one-time election, the existing treatment for accumulated other comprehensive income.  The final rules took effect for community banks on January 1, 2015, subject to a transition period for certain parts of the rules.  At September 30, 2017 the Bank (on a stand-alone basis) continued to qualify as a well-capitalized institution, and the Company continued to exceed the minimum required capital ratios applicable to it, under the capital adequacy guidelines described above.
The consolidated total capital and Tier 1 capital of the Company at September 30, 2017 includes an aggregate of $17.0 million principal amount of the $17.5 million of 30-year junior subordinated debentures that we issued in 2002 and 2004 (the “Debentures”). See “—Contractual Obligations—Junior Subordinated Debentures” below for additional information. We contributed the net proceeds from the sales of the Debentures to the Bank, thereby providing it with additional cash to fund the growth of its banking operations and, at the same time, to increase its total capital and Tier 1 capital.
Quarterly interest payments on the Debentures require prior approval of the FRBSF. As of September 30, 2017, we were current on all interest payments.
Dividend Policy and Share Repurchase Programs.
It is, and since the beginning of 2009 it has been, the policy of the Boards of Directors of the Company and the Bank to preserve cash to enhance our capital positions and the Bank’s liquidity. In addition, we have agreed that the Bank will not, without the FRB and the CDBO's prior written approval, pay any dividends to Bancorp. Accordingly, we do not expect to pay dividends or make share repurchases for the foreseeable future.
The principal source of cash available to a bank holding company consists of cash dividends from its bank subsidiaries. There are currently several restrictions on the Bank’s ability to pay us cash dividends. Government regulations, including the laws of the State of California, as they pertain to the payment of cash dividends by California state chartered banks, limits the amount of funds that the Bank is permitted to dividend to us. Further, Section 23(a) of the Federal Reserve Act limits the amounts that a bank may loan to its bank holding company to an aggregate of no more than 10% of the bank subsidiary’s capital surplus and retained earnings and requires that such loans be secured by specified assets of the bank holding company. We have committed to obtaining approval from the FRB and the CDBO prior to Bancorp paying any dividends, or making any distributions representing

51


interest, principal or other sums on subordinated debentures or trust preferred securities. There can be no assurance that our regulators will approve such payments or dividends in the future. Refer to “Regulatory Matters” in Item 1 of our 2016 Form 10-K and Note 14, Shareholders’ Equity in the notes to our consolidated financial statements on our 2016 Form 10-K for more detail regarding the regulatory restrictions on our and the Bank's ability to pay dividends. While restrictions on the payment of dividends from the Bank to us exist, there are no restrictions on the dividends that PMAR may pay us. As of September 30, 2017, PMAR has approximately $1.9 million in assets and could provide us with additional cash if required. In addition, we currently have sufficient cash on hand to meet our cash obligations. As a result, we do not expect that these restrictions will impact our ability to meet our cash obligations.

Off-Balance Sheet Arrangements
Loan Commitments and Standby Letters of Credit. To meet the financing needs of our customers in the normal course of business, we are a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. At September 30, 2017 and December 31, 2016, we were committed to fund certain loans including letters of credit amounting to approximately $323 million and $317 million, respectively.
Commitments to extend credit and standby letters of credit generally have fixed expiration dates or other termination clauses and the customer may be required to pay a fee and meet other conditions in order to draw on those commitments or standby letters of credit. We expect, based on historical experience, that many of the commitments will expire without being drawn upon and, therefore, the total commitment amounts do not necessarily represent future cash requirements.
To varying degrees, commitments to extend credit involve elements of credit and interest rate risk for us that are in excess of the amounts recognized in our balance sheets. Our maximum exposure to credit loss in the event of nonperformance by the customers to whom such commitments are made could potentially be equal to the amount of those commitments. As a result, before making such a commitment to a customer, we evaluate the customer’s creditworthiness using the same underwriting standards that we would apply if we were approving loans to the customer. In addition, we often require the customer to secure its payment obligations for amounts drawn on such commitments with collateral such as accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, residential properties and properties under construction. As a consequence, our exposure to credit and interest rate risk on such commitments is not different in character or amount than risks inherent in the outstanding loans in our loan portfolio.
Standby letters of credit are conditional commitments issued by the Bank to guarantee a payment obligation of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.
Contractual Obligations
Borrowings. As of September 30, 2017, we had $15.0 million of outstanding borrowings from the FHLB. These borrowings matured and were repaid on October 2, 2017. The interest rate on these borrowings was 1.14%. At September 30, 2017, $642 million of loans were pledged to support our unfunded borrowing capacity. At September 30, 2017, we had unused borrowing capacity of $294 million with the FHLB.
The highest amount of borrowings outstanding at any month-end during the nine months ended September 30, 2017 was $15.0 million. The highest amount of borrowings outstanding at any month end in 2016 consisted of $15.0 million of borrowings from the FHLB.
Junior Subordinated Debentures. Pursuant to rulings of the Federal Reserve Board, bank holding companies were permitted to issue long term subordinated debt instruments that, subject to certain conditions, would qualify as and, therefore, augment capital for regulatory purposes. At September 30, 2017, we had outstanding approximately $17.5 million principal amount of Debentures, of which $17.0 million qualified as additional Tier 1 capital for regulatory purposes as of September 30, 2017.
Set forth below is certain information regarding the Debentures:
Original Issue Dates
Principal Amount
 
Interest Rates
 
Maturity Dates(1)
September 2002
$
7,217

 
LIBOR plus 3.40%
 
September 2032
October 2004
10,310

 
LIBOR plus 2.00%
 
October 2034
Total
$
17,527

 
 
 
 
 
 
(1)
Subject to the receipt of prior regulatory approval, we may redeem the Debentures, in whole or in part, without premium or penalty, at any time prior to maturity.

52


These Debentures require quarterly interest payments, which are used to make quarterly distributions required to be paid on the corresponding trust preferred securities. Subject to certain conditions, we have the right, at our discretion, to defer those interest payments, and the corresponding distributions on the trust preferred securities, for up to five years. Exercise of this deferral right does not constitute a default of our obligations to pay the interest on the Debentures or the corresponding distributions that are payable on the trust preferred securities. We have committed to obtaining approval from the FRB and the CDBO prior to making any distributions representing interest, principal or other sums on subordinated debentures or trust preferred securities. Refer to “Regulatory Matters” in Item 1 of our 2016 Form 10-K for further detail. As of September 30, 2017, we were current on all interest payments. There can be no assurance that our regulators will approve such payments in the future.
Credit Risk
Credit risk is the risk of loss arising from adverse changes in a client’s or counterparty’s ability to meet its financial obligations under agreed-upon terms. Credit risk primarily exists in our loan and investment portfolio. The degree of credit risk will vary based on many factors including the duration of the transaction, the financial capacity of the client, the contractual terms of the agreement and the availability and quality of collateral. We manage credit risk by limiting the total amount of credit extended to a single borrower relationship, by verification of its business operations and assets and with a thorough understanding of the nature and scope of the business activities in which they are engaged.
As appropriate, management and Board level committees evaluate and approve credit standards and oversee the credit risk management function related to loans and investments. These committees’ primary responsibilities include ensuring the adequacy of our credit risk management infrastructure, overseeing credit risk management strategies and methodologies, monitoring economic and market conditions that may impact our credit-related activities, and finally, evaluating and monitoring overall portfolio credit risk.
We maintain a comprehensive credit policy that includes specific underwriting guidelines as well as standards for loan origination and reporting as well as portfolio management. The credit policy is developed by credit management and approved by the Board of Directors, which also reviews it at least annually. In addition, the credit policy sets forth requirements that ensure compliance with all applicable laws and regulatory guidance.
Our underwriting guidelines outline specific standards and risk management criteria for each lending product offered. Loan types are further segmented into subsections where the inherent credit risk warrants detailed transaction and monitoring parameters, as follows:
Loan structures, which includes the lien priority, amortization terms and loan tenors;
Collateral requirements, coverage margins and valuation methods;
Underwriting considerations which include recommended due diligence and verification requirements; and
Specific credit performance standards. Examples include minimum debt service coverage ratios, liquidity requirements as well as limits on financial leverage.
We measure and document each loan’s compliance with our policy criteria at underwriting. If an exception to these criteria exists, an explanation of the factors that mitigate this additional risk is considered before an approval is granted. A report of loans with policy exceptions is reported to the Credit Policy Committee of the Board of Directors of the Bank on a monthly basis.
We continuously monitor a client’s ability to perform under its obligations. Reporting requirements and loan covenants are set forth in each loan approval and compliance with these items are monitored on at least an annual basis or more frequently as conditions warrant. Loan covenant compliance is tracked and results are reported to credit management.
Under our credit risk management structure, each loan is assigned an internal asset quality rating that is based on defined credit standards. While the criteria may vary by product, each rating focuses on the borrower’s inherent operating risks, the quality of management, historical financial performance, financial capacity, the stability of profits and cash flow, and the adequacy of the secondary repayment sources. Asset quality ratings for each loan are monitored and reassessed on an ongoing basis. If necessary, ratings are adjusted to reflect changes in the client's financial condition, cash flow, financial position, or the absence of current financial information. During the three months ended September 30, 2016, the Company downgraded $48 million in loans as part of a comprehensive credit review. During the year subsequent to September 30, 2016, the Company has received $33.7 million in principal payments, net of advances, on these loans, $5.5 million in loan upgrades have been made and there have been charge-offs of $1.6 million on these loans, accounting for 85% of the total amount of loans downgraded during the third quarter of 2016. The loan upgrades were reviewed and confirmed by third parties during the first half of 2017. The Company anticipates the progress on the remaining $7.2 million in loan downgrades taken in the third quarter of 2016 to be reflected in our results in future reporting periods, and cannot predict the timing as to when these credits will be resolved. Refer to “Financial Condition — Allowance for Loan and Lease Losses” above in this Item 2 for further detail regarding our internal asset quality ratings.
The Bank recognizes that substantial risks are posed by concentrations of credit assets. As such, it seeks to maintain a diversified loan portfolio by limiting exposures by loan structure, business type or purpose, collateral type, and perceived asset

53


quality. Credit management defines areas of concentration, recommends appropriate thresholds to the Board of Directors and takes action if needed to manage potential risk where asset concentrations exist.

Market Risk
Market risk is the risk that values of assets and liabilities or revenues will be adversely affected by changes in market conditions such as interest rate fluctuations. This risk is inherent in the financial instruments associated with our operations and/or activities, including loans, securities and short-term borrowings.
The primary market risk to which we are exposed is interest rate risk, which is inherent in the financial instruments associated with our operations, primarily including our loans, deposits and borrowings. Interest rate risk is the exposure of a company’s financial condition, both earnings and the market value of assets and liabilities, to adverse movements in interest rates. Interest rate risk results from differences in the maturity or timing of interest earning assets and interest bearing liabilities, changes in the slope of the yield curve over time, imperfect correlation in the adjustment of rates earned and paid on different instruments with otherwise similar characteristics (e.g. three-month Treasury bill versus three-month LIBOR) and from interest-rate-related options embedded in bank products (e.g. loan prepayments, floors and caps, callable investment securities, customers redeploying non-interest bearing to interest bearing deposits, etc.).
The potential impact of interest rate risk is significant because of the liquidity and capital adequacy consequences that reduced earnings or net operating losses caused by a reduction in net interest income imply. We recognize and accept that interest rate risk is a routine part of bank operations and will from time to time impact our profits and capital position. The objective of interest rate risk management is to control exposure of net interest income to risks associated with interest rate movements in the market, to achieve consistent growth in net interest income and to profit from favorable market opportunities.
We measure interest rate risk and the effect of changes in market interest rates using a net interest income simulation analysis. The analysis incorporates our balance sheet as of September 30, 2017 and assumptions that reflect the current interest rate environment. The analysis estimates the interest rate impact of a parallel increase in interest rates over a twelve-month horizon.
The analysis below incorporates our assumptions for the market yield curve, pricing sensitivities on loans and deposits, reinvestment of asset and liability cash flows, and prepayments on loans and securities. The new loans, investment securities, borrowings and deposits are assumed to have interest rates that reflect our forecast of prevailing market terms. We also assumed that LIBOR and prime rates do not fall below 0% for loans and borrowings. FHLB borrowings are assumed to convert to cash as they run off. Actual results may differ from forecasted results due to changes in market conditions as well as changes in management strategies.
The estimated changes in net interest income for a twelve-month period based on changes in the interest rates applied as of September 30, 2017 were as follows:
Change in Market Interest Rates (basis points)
 
Amount ($)
 
Percent (%)
 
 
(in thousands)
 
 
+200
 
$
3,881

 
8.7
 %
+100
 
1,929

 
4.3
 %
-100
 
(3,894
)
 
(8.7
)%
In addition to NII simulation, we measure the impact of market interest rate changes on our economic value of equity (“EVE”). EVE is defined as the net present value of assets, less the net present value of liabilities, adjusted for any off-balance sheet items.
The estimated changes in EVE in the following table are based on a discounted cash flow analysis which incorporates the impacts of changes in market interest rates. The model simulations and calculations are highly assumption-dependent and will change regularly as our asset/liability structure changes, as interest rate environments evolve, and as we change our assumptions in response to relevant market or business circumstances. These calculations do not reflect the changes that we anticipate or may make to reduce our EVE exposure in response to a change in market interest rates as part of our overall interest rate risk management strategy. As with any method of measuring interest rate risk, certain limitations are inherent in the method of analysis presented in the preceding table. We are exposed to yield curve risk, prepayment risk and basis risk, which cannot be fully modeled and expressed using the above methodology. Accordingly, the results in the following table should not be relied upon as a precise indicator of actual results in the event of changing market interest rates. Additionally, the resulting changes in EVE and NII estimates are not intended to represent, and should not be construed to represent the underlying value.

54


The estimated changes in EVE based on interest rates applied as of September 30, 2017 were as follows:
Change in Market Interest Rates (basis points)
 
Amount ($)
 
Percent (%)
 
 
(in thousands)
 
 
+200
 
$
19,450

 
12.5
 %
+100
 
10,342

 
6.7
 %
-100
 
(1,045
)
 
(0.7
)%

Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) and general practices in the banking industry. Certain of those accounting policies are considered critical accounting policies, because they require us to make assumptions and judgments regarding circumstances or trends that could affect the carrying value of our material assets, such as, for example, assumptions regarding economic conditions or trends that could impact our ability to fully collect our loans or ultimately realize the carrying value of certain of our other assets, such as securities available for sale and our deferred tax asset. Those assumptions and judgments are based on current information available to us regarding those economic conditions or trends or other circumstances. If adverse changes were to occur in the conditions, trends or other events on which our assumptions or judgments had been based, then under GAAP it could become necessary for us to reduce the carrying values of any affected assets on our balance sheet. In addition, because reductions in the carrying value of assets are sometimes effectuated by or require charges to income, such reductions also may have the effect of reducing our income.
There have been no significant changes during the nine months ended September 30, 2017 to the items that we disclosed as our critical accounting policies and estimates in Critical Accounting Policies within Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our 2016 Form 10-K.

ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to certain financial risks, which are discussed in detail in Management’s Discussion and Analysis of Financial Condition and Results of Operations in the Credit Risk and Market Risk sections.

ITEM 4.     CONTROLS AND PROCEDURES

Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognized that any system of controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, as ours are designed to do, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by SEC rules, an evaluation was performed under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer of the effectiveness, as of September 30, 2017, of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2017, the Company’s disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in the reports that we file under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.
Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting during the three months ended September 30, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS
We are subject to legal actions that arise from time to time in the ordinary course of our business. Currently, neither we nor any of our subsidiaries is a party to, and none of our or our subsidiaries' property is the subject of, any material legal proceeding.

ITEM 1A. RISK FACTORS
There have been no material changes in our assessment of our risk factors from those set forth in our 2016 Form 10-K.

ITEM 6. EXHIBITS
The Index to Exhibits attached hereto is incorporated by reference.

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on November 3, 2017.
 
PACIFIC MERCANTILE BANCORP
 
 
By:
 
/S/   THOMAS M. VERTIN
 
 
Thomas M. Vertin
 
 
President and Chief Executive Officer
 
 
(Principal Executive Officer)
PACIFIC MERCANTILE BANCORP
 
 
By:
 
/S/   CURT A. CHRISTIANSSEN
 
 
Curt A. Christianssen
 
 
Chief Financial Officer
 
 
(Principal Financial Officer)


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EXHIBIT INDEX
Exhibit No.
 
Description of Exhibit
 
 
 
 
3.1
 
 
 
 
3.2
 
 
 
 
3.3
 
 
 
 
3.4
 
 
 
 
3.5
 
 
 
 
3.6
 
 
 
 
3.7
 
 
 
 
3.8
 
 
 
 
31.1
 
 
 
31.2
 
 
 
 
32.1**
 
 
 
32.2**
 
 
 
 
Exhibit 101.INS
 
XBRL Instance Document
 
 
Exhibit 101.SCH
 
XBRL Taxonomy Extension Schema Document
 
 
Exhibit 101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
Exhibit 101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document
 
 
Exhibit 101.LAB
 
XBRL Taxonomy Extension Labels Linkbase Document
 
 
Exhibit 101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document

** Furnished herewith.

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